Risk and Insurance

So why be concerned about RISK? Murphy's Law

"If anything can wrong, it will."

The Role of Risk

- Risk encompasses the potential provision of both an opportunity for gains as well as the negative prospect for losses. - Risk permeates the spectrum of decision making from goals of value maximization to goals of insolvency minimization

Risk management policy statements

- are the primary tools to communicate risk management objectives. The process of identifying all of a firm's risks and their values is a very detailed process and involves risk profiling.

producer

In many states, producer is another name for both agents and brokers.

Insureds

Individuals who transfer risk to a third-party.

Group insurance

Insurance provided by the employer for the benefit of employees.

Physical hazards

Tangible environmental conditions that affect the frequency and/or severity of loss.

Common risk measures: Semi-variance:

The average square deviation of values in a distribution. Example: CEO may be primarily interested in deviations below an expected profit level, and may be less concerned with deviations above expected profit level.

Perils

The causes of loss.

probability distribution

The collection of possible events together with their respective probabilities of occurrence is called a probability distribution.

Common risk measures: Range:

The distance between the highest possible outcome value to the lowest in a distribution.

Insurer

The third party that accepts the risks transferred by insureds

Common risk measures: Value at Risk (VaR)

The worst-case scenario dollar value loss (up to a specified probability level) that could occur for a company exposed to a specific set of risks. Need to have this amount to stave off insolvency with the specified level of probability.

Incurred losses

are both paid losses plus known but not yet paid losses.

Risk management information systems

are computerized data systems that allow a risk manager to quantify the organization's loss history

Risk Reduction Loss reduction

are efforts to lessen loss severity.

An underwriter

decides whether or not to insure exposures on which applications for insurance are submitted

Due diligence

examines every action and items in the financial statement of companies to ensure the data reflect true value. YOU MUST TEST THIS STUFF!!

Cash flow analysis

looks at the amount of cash that will be saved and brings it into today's present value.

Incurred but not reported (IBNR)

losses are estimated losses that insureds did not claim yet, but they are expected to materialize in the future.

insurers have used a variety of factors in their underwriting decisions

marital status living arrangements credit rating

balance sheet

provides a snapshot of a firm's assets and liabilities

Risk averse

refers to shying away from risks and preferring to have as much security and certainty as is reasonably affordable.

Personal Producing General Agent

sells for one or more insurers, often with a higher-than-normal agent's commission and seldom hires other agents.

Captive Insurance Company

- A company that provides insurance coverage to its parent company and other affiliated organizations. The captive is controlled by its policyholder-parent; forming a captive insurer is an expensive undertaking. - Usually started for tax purposes and/or lack of available coverage in the private market (ie, pollution liability, foreign coverage), plus the Opportunity Cost of money.

Risk Retention Groups

- A group that provides risk management and retention to a few players in the same industry who are too small to act on their own. - Formed by organizations engaged in similar businesses or activities; thus being exposed to the same types of liability. Coverage usually limited to liability risks

Options

- Agreements that give the right (but not the obligation) to buy or sell an underlying asset at a specified price at a specified time in the future. - A call option grants the right to buy at the strike price. This is done when you think the share price of the underlying security will rise. - A put option grants the right to sell at the strike price. This is done when you think the price of the underlying security will fall. - Also known as "cap" and "floor" defenses.

Swaps

- Agreements to exchange or transfer expected future variable-price purchases of a commodity or foreign exchange contract for a fixed contractual price today. - Also known as "switch out of it" defense. EXAMPLE: Exchanging an Adjustable Rate Mortgage for a Fixed Rate Mortgage.

Some areas for which ERMs of a firm need to involve themselves for risk mitigation: (ERMs) Enterprise risk Managers

- Building risk - Accounts receivables and notes due - Currency risk - Interest rate risk - Tools, furniture, and inventory - Capital structure (how a firm finances its operations by using different sources of funds like bonds, equity, notes-payable, etc.)

Transfer of risk:

- Displacement of risk to a third, unrelated party. - Some risks may be transferred through the formation of a corporation with limited liability for its stockholders. - Others may be transferred by contractual arrangements, including insurance, leases and rental agreements, hold-harmless clauses, and surety bonds.

Risk Management Process

- Identify Risk - things that might inhibit /enhance your ability to achieve objectives - Identify Controls - Reduce frequency (barricade), severity (harness/lanyard), transfer (insurance), avoid (don't do it!) - Implement RM Strategy - Monitor / evaluate results

The Risk Management Process

- Identify risks and assess them - Forecast future frequency and severity of losses - Mitigate risks - Find risk mitigation solutions - Create plans - Conduct cost-benefits analyses - Implement programs for loss control and insurance

The Risk Management Function Few responsibilities of a chief risk officer (CRO):

- Insurance and loss control - Use of specialized tools to keep cash flow in-house - Oversee the increasing reliance on capital market instruments to hedge risk - Address the entire risk map - Create risk management guidelines for the firm

Mutual Insurers

- Insurers owned and controlled, in theory if not in practice, by their policyowners. (New York Life) - Profits are shared with owners as policyowners' dividends. - Demutualization occurs when mutual companies convert to stock companies

Actuarial Analysis

- Is a highly specialized mathematic analysis that deals with the financial and risk aspects of insurance. - An actuary determines proper rates and reserves, certifies financial statements, participates in product development, and assists in overall management planning.

Risk Pooling (Loss Sharing)

- Loss sharing is accomplished through premiums collected by the insurer from all insureds. - Pooling can be done by any group who wishes to share in each other's losses. - It allows a more accurate prediction of future losses because there are more risk exposures. - In order for the law of large numbers to work, the pooled exposures must have approximately the same probability of loss.

Securitization

- Packaging and transferring the insurance risks to the capital markets through the issuance of a financial security, which is then sold to a willing buyer - Securitized catastrophe instruments can help a firm or an individual to diversify risk exposures when reinsurance is limited or not available EXAMPLE: Packaging wind risk for coastal properties. - Capital market solutions also allow the industry (insurers and reinsurers) to reduce credit risk exposure, also known as counterparty risk

Financial firm vs. an Insurer Insurance companies are in two businesses:

- The insurance and investment businesses. - The insurance side involves underwriting and reserving liabilities. - The investment side includes decisions about asset allocation (adjusts a portfolio's asset percentage based on investor risk tolerance). This is done through Rebalancing.

Risk Transfer

- The insurer assumes risk by promising to pay whatever loss may occur as long as it fits the description given in the policy and is not larger than the amount of insurance purchased. - The insurance contract stipulates what types of losses will be paid by the insurer. - Most insurance contracts are expressed in terms of money, although some compensate insureds by providing a service (health insurance) - Insurance cannot compensate for psychological or sentimental value.

Adverse Selection

- The phenomenon of selecting an insurer that charges lower rates for a specific risk exposure. - Adverse selection occurs when insurance is purchased more often by people with higher than expected losses than by people with average or lower expected losses. - Some insurance policy provisions are designed to reduce adverse selection. EXAMPLE: Life insurance policies don't pay if you commit suicide within two years of policy inception EXAMPLE: Flood policies don't pay if the loss occurred within 30 days of policy inception EXAMPLE: You can only make changes in health insurance during "open enrollment" periods.

Model

- is a symbolic representation of the possible outcomes and their likelihoods or relative frequencies. - To manage future risks under uncertainty, a model is required.

The law of Large Numbers (LLN)

- is a theorem that describes the result of performing the same experiment a large number of times. According to the law, the average of the results obtained from a large number of trials should be close to the expected value, and will tend to become closer as more trials are performed. - The LLN is important because it "guarantees" stable long-term results for the averages of some random events. For example, while a casino may lose money in a single spin of the roulette wheel, its earnings will tend towards a predictable percentage over a large number of spins. Any winning streak by a player will eventually be overcome by the parameters of the game. It is important to remember that the LLN only applies (as the name indicates) when a large number of observations are considered. There is no principle that a small number of observations will coincide with the expected value or that a streak of one value will immediately be "balanced" by the others

Reinsurance

- is an arrangement by which an insurance company transfers all or a portion of its risk under a contract (or contracts) of insurance to another company How Reinsurance Works ---Reinsurance may be divided into three types: treaty, facultative, and a combination of these two. ---Each of these types may be further classified as proportional or nonproportional.

Catastrophic loss

- is loss that could imperil the insurer's solvency; may occur in two circumstances. - All or many units of the group are exposed to the same loss-causing event; exposure units are susceptible to dependent loss when loss to one exposure unit affects the probability of loss to another. EXAMPLE: Katrina A single large value may be exposed to loss. EXAMPLE: World Trade Center

Fair value

- is the numerical average of the experience of all possible outcomes; also called the "expected value." - The expected value is calculated by multiplying each probability by its respective gain or loss; also referred to as the mean value, or the average value.

Common risk measures: The Capital Asset Pricing Model (CAPM) Beta Measure of Non-diversifiable Portfolio Risk

- model provides a measure of how the return on an asset systematically varies with the variations in the market, and consequently a measure of systematic risk. - CAPM assumes that investors expect to be compensated for both the time value of money and the systemic (non-diversifiable) risk they bear. - CAPM is useful when assessing systematic financial risk or the additional risk involved in adding an asset to an already diversified portfolio. - Risk premium is the premium over and above the actuarially fair premium that a risk-averse person is willing to pay to get rid of risk. It measures the compensation for the systematic risk the investors bear.

Independent Agent

- usually represents several companies, pays all agency expenses, is compensated on a commission plus bonus basis, and makes all decisions concerning how the agency operates. Example: Virginia Commonwealth Corporation - An independent agent owns the x-date; that is, he or she has the right to contact the customer when a policy is due for renewal.

Risk mapping has five main objectives:

1) Aid in the identification of risks and their interrelations. 2) Provide a mechanism to see clearly what risk management strategy would be the best to undertake. 3) Compare and evaluate the firm's current risk handling and to aid in selecting appropriate strategies. 4) Show the leftover risks after all risk mitigation strategies are put in place. 5) Easily communicate risk management strategy to both management and employees.

Risk managers can maximize values by:

1) Ascertaining—before the damage occurs—that an arrangement will provide equilibrium between resources needed and existing resources. Example: Is premium paid for coverage received reasonable? 2) Making sure values are aligned Example: Executive stock options Example: Amount of insurance to buy 3) Evaluating the firm's ability or capacity to sustain (absorb) damages

How Insurance Works?

1. Risk is transferred from an individual or entity (the insured) to a third party (the insurer) 2. The insurer pools all of the risk exposures together to compute potential future losses with some level of accuracy. 3. The pooling of risk leads to an overall reduction in risk in society because insurer's accuracy of prediction improves as the number of exposures increases. 4. The amount of risk that is transferred is usually the key to determining whether a certain accounting transaction is considered insurance or not.

Risk Profiling:

A process that evaluates all the risks of the organizations and measures the frequency and severity of each risk.

Insurance

A social device in which a group of individuals transfer risk to another party such that the third party combines or pools all the risk exposures together.

Intangible hazards

Attitudes and nonphysical cultural conditions can affect loss probabilities and severities of loss.

Natural perils

Causes of losses over which people have little control.

Economic perils

Causes of losses resulting from the state of the economy.

Human perils

Causes of losses that lie within individuals' control.

Risk mapping:

Charting entire spectrums of risk, not individual risk "silos" from each separate business unit. Risk identification and estimates of frequency and severity Plotting the risk map

Direct writers

Companies that market insurance through exclusive agents. Example: State Farm

Hazards

Conditions that increase the cause of loss; they may increase the probability of losses, their frequency, their severity, or both. - Hazards are critical as our ability to reduce their effects will reduce both overall costs and variability

Common risk measures: Deviation from a central value:

Considers not just the most extreme values of the distribution, but all values and their respective occurrence probabilities.

Morale Hazard

Describes an insured person's attitude about his belongings. It arises when the person does not care about his possessions because he knows he is insured. Example: Leaving the house door unlocked because you have insurance.

Government Risk Pools

Different governmental organizations with similar risks (ie, county school systems) come together to combine risks and increase their insurance purchasing power.

Distribution

Displaying events on a map to tell us the relative likelihood that an event will occur.

Private or Government Insurance

Example: FAIR (Fair Access To Insurance Requirements) Plans, Crop Insurance

Life/health insurance

Insurance that covers exposures to the perils of death, medical expenses, disability, and old age

Property/casualty insurance

Insurance that covers property exposures such as direct and indirect losses of property caused by perils such as fire, windstorm, and theft.

Personal insurance

Insurance that is purchased by individuals and families for their risk needs; such insurance includes life, health, disability, auto, homeowner, and long-term care.

Stock Insurers

Insurers created for the purpose of making a profit and maximizing the value of the organization for the benefit of the stockholders (Travelers)

Moral Hazard

Involves a conscious change in behavior to try to benefit from an event that could occur. Example: Skydiving after purchasing life insurance

Investments Gross Profit:

Occurs when premiums collected + investment income exceeds losses paid + expenses.

Investments Underwriting Profit:

Occurs when premiums collected exceed losses paid. Gross Profit: Occurs when premiums collected + investment income exceeds losses paid + expenses.

Types of Risks--Risk Exposures

Personal loss exposures (personal pure risk) Property loss exposures (property pure risk) Liability loss exposures (liability pure risk) -Liability loss is loss caused by a third party who is considered at fault.

Commercial insurance

Property/casualty insurance for businesses and other organizations.

Pure versus speculative risk exposures Pure risk: Speculative / business risk:

Pure risk: Risk that features only two possible outcomes - loss or no loss. Speculative / business risk: Risk that features a chance to either gain or lose.

Risk Assumption - A risk retention group

Risk Assumption The extent to which risk retention is feasible depends upon the accuracy of loss predictions and the arrangements made for loss payment. A risk retention group provides risk management and retention to a few players in the same industry who are too small to act on their own.

Risk management function with regard to the balance sheet of financial institutions:

Risks from the liabilities Computed by actuaries using mortality tables and life expectancy tables Risks from the asset mix

Engineering and loss control

Service concerned with methods of prevention and reduction of loss whenever the efforts required are economically feasible.

Probability

The chance that something will happen. How likely it is that some event will occur? The word probability can have two different meanings or forms as related to statements of uncertain outcomes. - The first is probability as a degree of belief about whether an event will occur and how firmly this belief is held. Example: Columbus believed, but was not sure, that if he sailed west, he would find India - The second interprets probability as a relative frequency of occurrence in repeated trials. Example: Flipping a coin. What are the chances of heads?

Common risk measures: Maximum Probable Annual Loss (MPAL)

The largest loss that could result from an occurrence assuming protective measures (ie, sprinkler, fire alarm, levies, air bags) function as believed.

Enterprise Risk

The opportunities in the risks and the fear of losses encompass the holistic risk or the enterprise risk of an entity. Enterprise risk management (ERM) is one of today's key risk management approaches.

Likelihood:

The probability that an even will occur in a specified amount of time

Government Insuring Organizations

Usually formed to provide coverage where the private market cannot due to the risk not meeting the ideal requisites for private insurance.

Exclusive Agents

are permitted to represent only their company or a company in an affiliated group of insurance companies.

Fundamental risk or systemic risk

are risks that are pervasive to and affect the whole economy, as opposed to accidental risk for an individual. - Catastrophic loss exposure

Rate calculations

are the computations of how much to charge for insurance coverage once the ultimate level of loss is estimated, plus factors for taxes, expenses, and returns on investments.

Risk neutral

attitude is seen when one's risk preference lies between the extremes of risk averse and risk seeking.

Loss prevention

efforts seek to reduce the probability of a loss occurring.

A firm's brand equity

entails the value created by a company with a good reputation and good products.

Financial statements

include the income statements (measures company's financial performance over a specific accounting period) balance sheets, and Cash Flow Statement (net amount of cash and cash equivalents moving in and out of the business).

Forecasting

involves projecting the frequency and severity of losses into the future based on current data and statistical assumptions.

Data warehousing

is a system of housing large sets of data for strategic analysis and operations.

General Agent

is an independent businessperson rather than an employee of the insurance company and is authorized by contract with the insurer to sell insurance in a specified territory.

Broker

is an individual who solicits business from the insured and also acts as the insured's legal agent when the business is placed with an insurer.

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.

Loss development

is the calculation of how amounts paid for losses increase (or mature) over time for the purpose of future projection.

Risk premium

is the premium over and above the actuarially fair premium that a risk-averse person is willing to pay to get rid of risk. It measures the compensation for the systematic risk the investors bear.

Underwriting

is the process of classifying the potential insureds into the appropriate risk classification in order to charge the appropriate rate (ie, assembling homogenous groups that allow the Law of Large Numbers to work).

Service

is the ultimate indicator on which the quality of the product provided by insurance depends. Policy language is fairly standard across competitors. Service and price are the main differentiators.

Risk

is the uncertainty about a future outcome, particularly the consequences of a negative outcome. - Uncertainty is having two potential outcomes for an event or situation. - Uncertainty about which of several possible outcomes will occur defines the meaning of risk.

Risk management matrix

provides alternative financial action to undertake for each frequency/severity combination on the risk map.