FIRE Exam 1
How do you find the EXPECTED value of losses per claim over a three year period? (chp.2)
=(Avg loss per claim Yr 1 +Yr 2 +Y3/ 3 Years)
Explain the differences between company adjusters and independent adjusters. Given the choice, who would you prefer to deal with in managing your claim? Why?(Chp.7)
A company adjuster is an employee of an insurer who handles claims. An independent adjuster is an employee of an adjusting firm who works for several different insurers and receives a fee for each claim handled. Student answers of their preference to deal with company adjusters or independent adjusters will vary. Students should, however, give valid reasons for their preference.
Explain how swaps work to mitigate the interest rate risk. Give an example.
A swap is a derivative in which two counterparties exchange certain benefits of one party's financial instrument for those of the other party's financial instrument. For example, Company X has comparative advantage in fixed interest rate markets but is currently while Company Y has comparative advantage in floating interest rate markets. Company X is currently paying floating, but wants to pay fixed. Company Y is currently paying fixed but wants to pay floating. By entering into an interest rate swap, each company can 'swap' their existing obligation for their desired obligation. Company Y makes periodic interest payments to Company X based on a floating interest rate (say, LIBOR +75 basis points). Company X in turn makes periodic interest payments based on a fixed interest rate (say, 9.25%).
What examples can you cite of quantitative consequences of uncertainty and a qualitative or emotional consequence of uncertainty?(chp. 1)
A trader placing a stock futures buy or sell order faces an uncertainty - the consequences of which are quantitative in nature. Burt is on his way to his ten year college reunion. He meets with an accident on the way and is unable attend it. This is an example of a qualitative or emotional consequence of uncertainty.
What are the advantages of reinsuring?(Chp.7)
Advantages of reinsurance include: ● protection against excess losses and catastrophe for the ceding insurer, ● opening new business opportunities through increased capacity, ● financial stability from spreading risk, ● increased underwriting capacity of the insurer, ● reduction of the unearned premium reserve, ● greater efficiencies for agents by allowing large risks to be placed with a single company, ● increased competition by helping smaller companies remain in business. ● allowing an insurer to exit a territory or line of insurance.
Why are insurers using credit scoring in their underwriting? In what areas is it possible to misjudge a potential insured when using credit scoring? What other underwriting criteria would you suggest to replace the credit scoring criterion?(Chp.7)
Although it seems obvious that insurance companies use credit scoring in their underwriting to check for an individual's ability to pay premiums, this is not the case. Rather, it's the strong relationship between credit scores and the likelihood of filing a claim that they analyze. E.g. Someone who spends money recklessly is also likely to drive recklessly; someone who is lazy about making credit card payments is apt to be lazy about trimming a tree before it causes roof damage. However, using credit scores in this manner is discriminatory and inflexible. An individual's behavioral patterns cannot be judged by their credit scores. E.g. If an individual has poor credit score because he got laid off due to terrorism, that has nothing to with that individual laziness or ability to drive. Student answers for suggestions to replace the credit scoring criterion will vary.
What examples fit under uncertainties and consequences? Which are the risks?(chp. 1)
An individual could or could not get caught driving under the influence of alcohol. If caught, it may cause loss of respect by peers, higher car insurance rates, or cancellation of auto insurance. In this case, risk is the negative consequence of the uncertainty of getting caught under the influence of alcohol. Hence, the risks are the loss of respect by peers, higher car insurance rates, or cancellation of auto insurance.
If an insurance company invests in the stock market, what type of instrument would the insurer use to mitigate the risk of stock price fluctuations? (Chp.5)
An insurance company investing in the stock market would use futures or options or both to mitigate the risk of stock price fluctuations.
Explain whether the following risks and perils are insurable by private insurers: e. biological warfare (chp.6)
Biological warfare is not insurable because it is an "act of war" and would cause catastrophic losses.
How does e-risk fit into the categories of risk?(chp. 1)
Companies conducting business over the Internet have three major exposures to protect: intellectual property (copyrights, patents, trade secrets), security (against viruses and hackers), and business continuity (in case of system crashes). All these exposures are pure risks. These companies are also exposed to speculative risks such as market risk, product success risk, and investment risk.
Explain whether the following risks and perils are insurable by private insurers: f. Dirty Bomb (Chp.6)
Dirty bombs are not insurable by private insurers because it can cause huge losses. However, government may provide insurance.
How does the risk management function contribute to firm goals? (chp.5)
Effective risk management can maximize firm value. The risk management function is involved in minimizing losses and maximizing opportunities. Risk management can add value by minimizing the risk of unused cash by investing them to maximize returns. They can insure various risks to minimize the impact of certain incidents. For a multinational firm, which operates in many companies, the risk function can add value by mitigating currency risks.
How might firm stakeholders' goals conflict? How might such conflicting goals affect value maximization objectives? (chp.5)
Employees in different departments have different goals. The goal of the sales team in an organization is to maximize sales. Similarly, the goal of the risk management team may be to minimize losses. These goals differ from a shareholders goal of maximizing profits. The risk management team, which may have the goal of minimizing losses may insure risks with high frequency and low severity, which otherwise could have been retained. This may result in lack of insurance of other risks which have low frequency and high severity, which need to be insured. This may result in losses and decrease a firm's value. It's very important not to create a conflict between the risk managers' interests and the firm's interests. For example, the subprime mortgage crisis ensued because of the conflict of interest between mortgage underwriters and mortgage bankers.
Why are finite risk programs not considered insurance? (chp.6)
Finite risk programs are not considered insurance because of two major reasons: ● The premiums paid finances potential losses (not risks). ● According to the rule, if there is no transfer of at least 10 percent of the risk, regulators regard the transaction as a noninsurance transaction.
Imagine that the step of evaluation of the risks did not account for related risks. What would be the result for the risk manager? (Chp.4)
If the evaluation of the risks does not account for related risks, the risk manager will be able to minimize specific risks only, which would mostly include pure risks. Risks cannot be segregated; they interact and affect one another.
Why is it necessary to discriminate in order to pool? (Chp.6)
In order for the law of large numbers to work, the pooled exposures must have approximately the same probability of loss. In other words, the exposures need to be homogeneous (similar). Insurers, therefore, need to discriminate, or classify exposures according to expected loss.
How do you decide which insurer carries more risk in losses and which carries more claims risk? (chp.2)
In this case, we can use the coefficient of variation to get the relative value of risk because the means of the distributions are not equal. The coefficient of variation for the collision losses for Insurer A; Standard deviation of collision losses/Mean of collision losses From the calculation, we see that the coefficient of variation for collision losses higher for Insurer A when compared to the coefficient of variation of Insurer B. We can therefore conclude that Insurer A carries more risk for collision losses.
What are the main organizational structures adopted by insurance companies? (Chp.6)
Insurance companies generally adopt one of the following organizational structures: ● Stock Insurers - These are organized in the same way as other privately owned corporations created for the purpose of making a profit and maximizing the value of the organization for the benefit of the owners. ● Mutual Insurers - These are owned and controlled by their policyowners. They have no stockholders and issue no capital stock. People become owners by purchasing an insurance policy from the mutual insurer. The stated purpose of the organization is to provide low-cost insurance rather than to make a profit for stockholders.
Why must insurance companies be concerned about the amount paid for a loss that occurred years ago? (chp.7)
Insurance companies need the amount paid for a loss that occurred years ago to conduct actuarial analysis, which is a highly specialized mathematic analysis that deals with the financial and risk aspects of insurance. Actuarial analysis takes past losses and projects them into the future to determine the reserves an insurer needs to keep and the rates to charge.
What is the definition of insurance? (Chp.6)
Insurance may be defined as a social device in which a group of individuals transfer risk to another party in such a way that the third party combines or pools all the risk exposures together.
What types of insurance are available? (Chp. 6)
Insurances can be differentiated by the following characteristics: ● Personal, Group, or Commercial Insurance ● Life/Health or Property/Casualty Insurance ● Private or Government Insurance ● Voluntary or Involuntary Insurance
How could you forecast the severity and frequency for next year ? (chp.4)
Linear regression; y=mx+b
Explain whether the following risks and perils are insurable by private insurers: d. mold (Chp.6)
Molds are insurable because the number of similar exposure units is large and the cost of coverage is economically feasible.
How do you find the mean losses per year for collision claims? (Chp.2)
Number of Collision claims/ (x) years
How do you find the probability than an exposure unit will file a claim? (chp.2)
Number of claims in year/Amount of exposure allotted for that year= 0.0xx or x.x%
Explain securitization and provide examples of insurance-linked securities. (Chp. 5)
Packaging and transferring the insurance risks to the capital markets through the issuance of a financial security is termed securitization. In securitization, the risks that have been underwritten are pooled together into a bundle, which is then considered an asset and the underwriter then sells its shares; hence the risk is transferred from the insurers to the capital markets. Various insurance companies' risks for similar exposures in diversified locations are combined in one package that is sold to investors. Examples of insurance-linked securities include catastrophe bonds, catastrophe risk exchange swaps, insurance-related derivatives/options, catastrophe equity puts (Cat-EPuts), contingent surplus notes, collateralized debt obligations (CDOs), and weather derivatives.
How do those risk attitudes fit into roles that lie behind the definition of risks?(chp. 1)
People are risk averse when they shy away from risks and prefer to have as much security and certainty as is reasonably affordable in order to lower their discomfort level. These people fit in the role of loss minimization. A risk seeker is someone who will enter into an endeavor as long as a positive long run return on the money is possible, however unlikely. These people fit in the role of value maximization. A risk neutral individual will not pay extra to have the risk transferred to someone else, nor will they pay to engage in a risky endeavor. They fit in the role in between loss minimization and value maximization.
Explain whether the following risks and perils are insurable by private insurers: c. A Flood (Chp. 6)
Private homeowner's insurance doesn't cover flood damage because it is a catastrophic loss. Flood damages are covered for by The National Flood Insurance Program (NFIP), which is a protection provided by the government
Provide examples of risk categories.(chp. 1)
Pure risks: The risk of physical damage to a property due to fire. Speculative risks: The risk of a new product failing in the market. Diversifiable or idiosyncratic risks: Individuals investing in stocks can diversify their return on investment by investing in stocks of companies in unrelated industries. Nondiversifiable or systemic risks: Examples include the Great Depression of the early 1930s, major wars, and the financial crisis of 2008.
Distinguish among the different types of reinsurance and give an example of each. (Chp.7)
Reinsurance may be divided into three types: (1) treaty, (2) facultative, and (3) a combination of these two. Each of these types may be further classified as proportional or nonproportional. In treaty insurance, the original insurer is obligated to automatically reinsure any new underlying insurance contract that meets the terms of a prearranged treaty, and the reinsurer is obligated to accept certain responsibilities for the specified insurance. Examples of classes covered by treaty reinsurance are all property insurance policies or all casualty insurance policies written by the reinsured. In a facultative arrangement, both the primary insurer and the reinsurer retain full decision-making powers with respect to each insurance contract. e.g. Facultative reinsurance agreements often cover catastrophic or unusual risk exposures. When the reinsurance agreement calls for proportional (pro rata) reinsurance, the reinsurer assumes a prespecified percentage of both premiums and losses. Expenses are also shared in accord with this prespecified percentage. For example, if the reinsured pays 40 percent of the premiums to the reinsurer, then the reinsured recovers 40 percent of its losses when it pays the original policyholder according to the original policy terms. The reinsured can only recover a portion of its total loss, not the entire amount. Nonproportional reinsurance obligates the reinsurer to pay losses when they exceed a designated threshold. For example, an insurer is prepared to accept a loss of $1 million and he (she) purchases a layer of reinsurance of $4 million in excess of $1 million. If a loss of $3 million occurs, then the insurer will retain $1 million and will recover $2 million from its reinsurer. In this example, the reinsured will retain losses exceeding $5 million unless he (she) has purchased a further excess layer of, let's say, $10 million in excess of $5 million.
When would you use loss control? (chp.4)
Retention with loss control should be used for risks with high frequency and low severity.
What is the formal definition of risk?(chp. 1)
Risk is the consequence of uncertainty and a deviation from expectations.
What are perils?(chp. 1)
Risk management professionals use the term peril to refer to "the causes of loss."
What are hazards?(chp. 1)
Risk professionals use the term hazards to refer to the conditions that increase "the causes of loss." Hazards may increase the probability of losses, their frequency, their severity or both.
When would you retain the risk? (chp.4)
Risk with low frequency and low severity should be retained.
Name the main categories of risks.(chp. 1)
Risks can be categorized into pure risks and speculative risks. Another breakdown is between catastrophic risks, such as flood and hurricanes, as opposed to accidental losses such as those caused by accidents such as fires. Yet another differentiation is by systemic or nondiversifiable risks, as opposed to idiosyncratic or diversifiable risks.
When would you avoid the risk? (chp. 4)
Risks with high severity and high frequency should be avoided.
What are the benefits of securitization in the insurance/reinsurance industry? (Chp. 5)
Securitization makes significant difference in the way insurance risk is traded—by making it a commodity and taking it to the capital markets in addition to or instead of to the insurance/reinsurance market. Various insurance companies' risks for similar exposures in diversified locations are combined in one package that is sold to investors. Securitized catastrophe instruments can help a firm or an individual to diversify risk exposures when reinsurance is limited or not available. Because global capital markets are so vast, they offer a promising means of funding protection for even the largest potential catastrophes. Capital market solutions allow the industry (insurers and reinsurers) to reduce credit risk exposure. Capital market solutions also diversify funding sources by spreading the risk across a broad spectrum of capital market investors.
A study of data losses incurred by companies due to hackers penetrating the Internet security of the firm found that 60 percent of the firms in the industry studied had experienced security breaches and that the average loss per security breach was $15,000. 1b. One firm had two breaches in one year and is contemplating spending money to decrease the likelihood of a breach. Assuming that the next year would be the same as this year in terms of security breaches, how much should the firm be willing to pay to eliminate security breaches (i.e., what is the expected value of their loss)? (chp.2)
Since 60% of the firms studied have experienced security breaches and the cost of a breach averages $15,000, the expected loss is 60% of $15,000 or .6 x 15,000 = $9,000 per security breach. However, this firm has experienced two breaches in one year. Assuming that next year would be the same, i.e. the firm would experience two security breaches, the expected loss for this company would be 2 * $9000 = $18000. Therefore, the firm should be willing to pay $18000 to eliminate security breaches.
Compare the investment (asset) portfolio of the life/health insurance industry to that of the property/casualty insurance industry. Why do you think there are differences? (Chp.7)
Since insurance companies match their assets and liabilities, the nature of the liabilities dictates the mix of the assets. Example of the asset allocation mix of the life industry versus the property/casualty industry is shown as follows:
How do you calculate the coefficient of variation of losses? (chp.2)
Standard Deviation/ mean of losses
Would you rather shop for insurance on the Internet or call an agent?(chp.7)
Student answers will vary. Some students may prefer shopping for insurance on the Internet while other would prefer to call an agent. However, students should be able to substantiate their preference. Shopping from the internet allows an individual to select an insurance product and compare the price and coverage. It, however, has the risk of fraud, and lack of clarity while choosing the policy. Calling an agent allows an individual to have a one-on-one conversation to clarify all the queries and to customize the policy according to the requirement. It, however, may provide limited choice of policies when compared to shopping from the Internet.
Advertising by the Independent Insurance Agents & Brokers of America extols the unique features of the American agency system and the independent agent. Its logo is the Big I. Does this advertising influence your choice of an agent? Do you prefer one type of agent to others? If so, why? (Chp.7)
Student answers will vary. They need to substantiate their answer. Some students may prefer exclusive agents, independent agents, and brokers according to the insurance policy. Some students may prefer independent agents, exclusive, salaried representatives and brokers according to their characteristics and what/whom they represent.
How do you find the average frequency of losses?
Sum of Collision Claims/ (x) years
How do you find the average severity of losses?(Chp.2)
Sum of Collision Loses/(x) years= Answer Answer/average frequency
How do you calculate the mean losses per exposure? (chp. 2)
Sum of Collision Losses/ (x) years =answer Answer/ Exposure amount.
How do you find the mean losses per claim per year for collision losses? (chp. 2)
Sum of Collision losses/ Sum of collision claims
Discuss the perils and hazards in box "Is Airport Security Worth It to You?" (chp. 1)
The September 11, 2001 terrorist attack can be referred to as a "peril." The lax safety measures in airports may be referred to as a "hazard" that increased the probability and severity of losses. The strict security measures that were followed after the 9/11 attack can be referred to as measures taken to reduce the hazards associated with terrorist attacks.
Year: 1 Number of Exposures: 10,000 Number of Collision Claims:375 Collision Loses:$350,000 What is the frequency of losses in year 1? (Chp.2)
The frequency in year 1 is 375.
Why is the government involved in insurance, and what are the governmental organizations listed in this section? (Chp.6)
The government is involved in insurance to fill the gap of covering exposures that private insurers have not insured. For example, exposures like flood and terrorism. Some government insurance programs exist for political reason. These insurers generally compete with private insurers. The governmental insuring organizations listed in this section are: ● Maryland automobile fund ● Wisconsin State Life Fund ● The Social Security Administration ● The Federal Deposit Insurance Corporation ● The National Credit Union Administration ● The Securities Investor Protection Corporation ● The Federal Crop Insurance Corporation ● The Federal Crime Insurance Program ● The National Flood Insurance Program ● The Veterans Administration ● The Pension Benefit Guaranty Corporation ● The Overseas Private Investment Corporation
What financial instrument might a jeweler use to cap his price for gold, the main raw material used in jewelry production? (chp.5)
The jeweler will use forward/future contracts to cap the price for gold.
What is the law of large numbers? Why do insurers rely on the law of large numbers? (Chp.6)
The law of large numbers holds that, as a sample of observations increases in size, the relative variation about the mean declines. Insurance contains the elements of risk pooling and risk transfer. The risk pooling creates a large sample of risk exposures and, as the sample gets larger, the possibility of missing future loss predictions gets lower (the law of large numbers). If it were not for the law of large numbers, insurance would not exist. A risk manager (or insurance executive) uses the law of large numbers to estimate future outcomes for planning purposes. The larger the sample size, the lower the relative risk, everything else being equal. The pooling of many exposures gives the insurer a better prediction of future losses.
What are the steps in the pure risk management process?(chp.4)
The logical steps in the pure risk management process include: a. Identifying risks b. Assessment of risks c. Forecasting future frequency and severity of losses d. Mitigating risks e. Finding risk mitigation solutions f. Creating plans g. Conducting cost-benefit analyses h. Implementing programs for loss control and insurance i. Evaluating programs once they are put into place
Discuss the different firm goals that companies seek to fulfill in the late 2000s. (chp.5)
The major firm goal that companies seek to is to maximize value. Firm goal of companies in the late 2000s is to add a long-term perspective to its goals to include sustainable value maximization.
Year: 1 Number of Exposures: 10,000 Number of Collision Claims:375 Collision Loses:$350,000 Calculate the probability of a loss in year 1. (chp.2)
The probability of a loss in year 1 = 375/10,000 = 0.0375.
A study of data losses incurred by companies due to hackers penetrating the Internet security of the firm found that 60 percent of the firms in the industry studied had experienced security breaches and that the average loss per security breach was $15,000. 1a. What is the probability that a firm will not have a security breach? (chp.2)
The probability that a firm will have a security breach is 60 %. Therefore, the probability that a firm will not have a security breach = 100 - 60 = 40%. Assuming all the firms in the industry are equally likely to have security breaches, the probability that a firm will not have a security breach is 40 percent.
What roles contribute to the definition of risk?(chp. 1)
The roles that contribute to the definition of risk are value maximization and insolvency minimization.
Name three risk attitudes that people display.(chp. 1)
The three risk attitudes that people display are risk averse, risk seeker, and risk neutral.
How would you classify the risks embedded in the financial crisis of fall 2008 within each of cross-classification?(chp. 1)
There were many risks involved in the financial crisis of fall 2008. Some of the major risks embedded in the financial crisis of fall 2008 were default risk, bankruptcy risk, and interest rate risk. We will now classify these risks between pure and speculative; nondiversifiable and diversifiable. Default risk: Pure risk; Diversifiable risk Bankruptcy risk: Pure risk; Diversifiable risk Interest rate risk: Speculative risk; Diversifiable risk
What is the relationship between uncertainty and risk?(chp. 1)
Uncertainty is having two or more potential outcomes for an event or situation. Risk has to do with consequences that are both positive and negative. Uncertainty about which of several possible outcomes will occur circumscribes the meaning of risk. Uncertainty lies behind the definition of risk. Risk is, therefore a consequence of uncertainty
What does an underwriter do? Why is the underwriting function in an insurance company so important? (Chp.7)
Underwriting is the process of classifying the potential insureds into the appropriate risk classification in order to charge the appropriate rate. An underwriter decides whether or not to insure exposures on which applications for insurance are submitted. They decide how much coverage the client should receive, how much they should pay for it, or whether to accept the risk and insure them. Underwriting involves measuring risk exposure and determining the premium that needs to be charged to insure that risk. In order for the law of large numbers to work, the pooled exposures must have approximately the same probability of loss. In other words, the exposures need to be homogeneous (similar). Insurers, therefore, need to discriminate, or classify exposures according to expected loss. This is the function of underwriters, which make them very important for insurance companies.
Why do we not just call perils and hazards by the name "risk," as is often done in common English conversations?(chp. 1)
We do not refer to perils and hazards by the name "risk" because they are different. Broadly, hazards are the conditions that increase perils. However, they are not perils. For example, when summer humidity declines and temperature and wind velocity rise in heavily forested areas, the likelihood of fire increases. Conditions are such that a forest fire could start very easily and be difficult to contain. In this case, fire can be referred to as a "peril" and the decline in humidity and the rise in temperature and wind, which can increase the fire and cause more damage, is referred to as "hazard." Risks exist due to perils, but the intensity of risks is due to hazards.
When would you buy insurance? (chp.4)
We should buy insurance for risks that have low frequency and high severity.
What is demutalization? (Chp.6)
When top managers of a mutual company decide they need to raise capital, they may go through a process called demutualization. A mutual company undergoes the process of demutualization to convert into a stock company.
Explain whether the following risks and perils are insurable by private insurers: The life of an eighty-year-old man(chp.6)
While most of the insurers would not insure an eight-year-old man, some insurers might. However, the person might have to pay face value or over for the policy i.e. if it's a $100,000 policy, the individual might have to pay $104,000. Policies of these kinds would only be beneficiary for the insurer.
Explain whether the following risks and perils are insurable by private insurers: a. A hailstorm that destroys your roof (Chp.6)
Yes, a hailstorm that destroys your roof is insurable peril because it is economically feasible.
In the allocation of costs, does the CRO need to understand the holistic risk map of the whole company? Explain your answer with an example. (Chp.4)
Yes, the CRO needs to understand the holistic risk map of the whole company. All risks in a company interact and affect one another. To identify and evaluate all risks in a company, the CRO needs to understand the holistic risk map of the whole company. For example, the reputation (business risk) of an organization is dependent on many factors which may include the sales team (operational risk), customer service(operational risk), product quality (business risk), etc. These factors are dependent on the company's strategy (business risk), employee satisfaction (business risk), quality of machinery (operational risk) etc. These factors may again be dependent on the financial position (credit risk) of the company. Understanding the risk map of the entire company would give the risk manager a clear idea about the allocation of costs for different risks.
How do you find the standard deviation of losses? (chp.2)
You can enter each years losses in STAT on Calc to find the Sx.
Four Types of Insurance
commercial, group, life/health, property/casualty.
Give examples for the following risk exposures: High-frequency and low-severity loss exposure (chp.4)
● Credit risk ● Earthquake ● Workers' compensation
Give examples for the following risk exposures: a. High-frequency and high-severity loss exposures. (Chp.4)
● Credit risk ● Interest rate risk ● Foreign Exchange risk
Give examples for the following risk exposures: c. Low-frequency and low-severity loss exposures (chp.4)
● E-risk ● Reputation Risk ● Intellectual property risk
Give examples for the following risk exposures: b. Low-frequency and high-severity loss exposures (chp.4)
● Fire ● Tornado ● Product liability ● Property liability ● IT system failure