Risk Management and Insurance #2

how can production factors be classified by scope of employment in the production process?

-general production factors: contribute to the production of more or all product categories -special production factors: contribute to the production of only one product category

What is retrocession?

When a reinsurer transfers risks he has underwritten onto another reinsurer

what is cross subsidy?

a sort of financing "bad risks" by "good risks"

What are production factors?

economic goods that are used for the production of other goods

why is experience rating only functional with high frequencies of losses?

if frequency of damage/losses is very low, then in the observation period (with a high probability) all risks observed will be without damage/loss and no premium differentiation will take place-- even if the frequency of loss of one type of risks is much higher than the frequency of loss of another type

Explain relative and absolute net risk premiums

-as an absolute NRP (amount of money shown in $$) -as a relative NRP (percentage of the sum insured)

How can insurers protect themselves from the "foreseeability" of risk?

-by asking a lot of questions before underwriting risks --> this is usually done in health insurance when knowledge of pre-existing conditions would cause the event of damage to occur

How is the value of production factors expressed?

by the factor prices that are paid on markets for the procurement or production factors

what is saving/dissaving business?

in some lines of insurance the risk business s connected with saving and/or dissaving business -for example in life insurance and in special forms of personal accident insurance and health insurance

What is meant by the criteria "unambiguousness" in technical insurability?

it is important that it can be identified if an when an event of damage occurs and what the amount of loss and indemnity will be

what is cost theory?

cost theory is about value structures -when employed production factor quantities are multiplied by production factor prices one arrives at cost theory

explain the substitution of money for indemnities and reinsurance

if an insurer does not take out reinsurance (only using money for indemnities) then retention is 100% and the insurer retains the whole profit expectation and entire technical risk if an insurer takes out reinsurance for his entire pool of insured risks then the profit expectation is smallest and the insurer bears no technical risk with the increasing substitution of money for indemnities for reinsurance; -the profit expectation is reduced (since reinsurance costs are higher than the expectancy values of losses reinsured) -the technical risk is reduced (reduction of absolute or relative spread of probability distributions insured)

How are contracts concluded a production factor?

in order to effect the risk balancing process, the insurer is in need of a pool of insured risks. that means that insurance contracts must have been concluded as a prerequisite for the risk balancing process -therefore contracts concluded are a production factor

explain the stochastic production function

in the risk business the employed quantities of the production factor "money for indemnities" are a stochastic (random) variable because money for indemnities depends on the actual losses in the portfolio of all insured risks

How is information a production factor in the risk business?

in the risk business, information is needed to help with calculating premiums and to help evaluate the risk balancing process and to also handle it by risk management measures

What is not taken into account in the pure method calculation of NRP?

inflation

What are "other businesses" of an insurance corporation?

insurance corporations produce services for third parties in the fields of: -financial services -management consulting services -data processing services -insurance broking

What is the factor price for "utilization of capital"?

interest rate

what are some characteristics of "reinsurance" as a production factor?

original/primary factor: bought from the outside (through a reinsurer) potential factor: because of long term business relations with a reinsurer that an insurer uses for his business (obligatory reinsurance) consumable factor: in particular cases of facultative reinsurance

what are some characteristics of utilization of capital as a production factor?

original/primary factor: stems primarily from the payments of the outside environment derivative/secondary factor: if capital stems from internal financing by accumulated earnings potential factor: safety capital/funds consumable factor: when used to pay indemnities

what are some characteristics or "contracts concluded" as a production factor?

potential factor: they make the risk balancing process possible derivative/secondary factor: if contracts are obtained by the insurers marketing primary/original factor: if contracts are obtained by purchase (mergers/acquisitions)

explain the substitution of "reinsurance" for "utilization of capital for safety fund"

reinsurance influences the probability distribution of losses from the whole portfolio, especially by reducing a spread endangering the insurer's existence safety funds can finance losses from the risk business -if the amounts of reinsurance taken out by the primary insurer is increased, then amounts of premiums for own account and losses for own account are reduced and therefore less safety funds are required

how is money for indemnities a production factor in risk business?

since the insurer promises to compensate damages in the event of damage/loss, insurance protection would not be possible without money for indemnities

what is surplus relief insurance?

surplus relief insurance is designed to control the primary insurer's solvency -by reinsurance contracts, especially in the form of high quota share contracts, the amounts relevant for the calculation of required provision from capital and reserves are reduced for a certain portfolio of risks insured OR the insurer's writing capacity is increased

what is meant by the criteria randomness in the technical approach to insurability?

that damage/loss of a risk cannot be foreseeable or manipulated in any way -you can't expect certain events to occur nor should the policyholder or any other persons be able to influence the risk adversely

explain the insurer's decision in the substitution of money for indemnities for reinsurance

the insurer has to decide on the proportion of production factors employed- his objectives are safety and profit and the insurer's decision will be dependent on the insurers attitude towards risk -the insurer will substitute money for indemnities with reinsurance as long as the marginal utility of additional safety (reduction in spread of losses) exceeds the marginal disutility of costs (reduction in expected value of profit) from additional reinsurance

what is the "condition of sustainable (technical) risk"?

the product "insurance protection makes only sense if the insurer is able to pay indemnities in the event of damage/loss therefore, insurance protection must always take place under the condition of sustainable technical risk so that there is only little risk of insolvency/failure -this makes the production of insurance different from many other businesses where it is irrelevant to the use of the product if the producer exists or not -basically the insurer needs to stay in business in order to pay indemnities and fulfill their contracts

explain the substitutional production function in risk business

the production function in risk business is not determined because production factors are mutually exchangeable without changing the outcome of the production in particular, substitutional production factors are; -money for indemnities and reinsurance -reinsurance and utilization of capital for safety funds

How is the external factor a production factor in the risk business?

the production of a single insurance is not possible without the supply of information by the insure/policy holder on the; -insuree/policyholder themselves -risks insured or to be insured -insured events therefore contribution of the external factor is a prereq for insurance production

What is insurability?

the question of whether a risk can be insured (insurable risk) or not (non-insurable risk)

What is the risk of cumulation?

the risk that one event simultaneously affects a large number of risks insured by an insurer

explain the inverse production function in risk business

the risk transfers are dependent on the products sold -only after the sale can the insurer know and decide on what quantities of each of the production factors have to be employed for the production of the respective product therefore we have an inverse production function (input is dependent on output)

What is meant by the criteria "ratability" criteria in technical insurability?

-for underwriting a risk it is essential that an adequate net risk premium can be calculated -if an adequate NRP cannot be calculated then there can be consequences like adverse selection

how can the production function in risk business be characterized (3 aspects)

-inverse production function -stochastic production function -substitutional production function

what makes information a production factor in the risk business?

-it is an economic good -obtained by the employment of scarce means/resources -either from outside (original factor) or inside (derivative factor) -which yields utility through its productive contribution

What are the production factors in risk business?

-money for indemnities -utilization of capital -reinsurance -contracts concluded -information -external factor

What kind of transfers of risk can be made between insurers?

-parts of single risks -parts of risks of certain types -parts of the total risk balancing risk

Distinguish experience rating from the other two forms of variable premiums

1. a system of sharing losses with the policyholders at the end of a period: here the eventual individual NRP of each policy holder is dependent on the record of total actual losses of the whole pool of risks 2. premium adaption clauses: here the NRP is dependent on general changes/developments of risk/loss influencing factors

What are the dimensions of utilization of capital?

1. quantitative dimension: amount of capital $$ 2. temporal dimension: duration of capital tied up in the investment

what is the production contribution of reinsurance?

1. reduces the primary insurer's technical risk 2. increases the primary insurers underwriting capacity

what is semi-obligatory reinsurance?

Facultative Obligatory: when the primary insurer can decide whether or not to pass on a risk to the reinsurer and the reinsurer is bound to assume the risk the submitted risks Obligatory Facultative: when the primary insurer MUST pass on certain risks to the reinsurer who can then decide whether or not to assume these risks

How do you achieve risk equivalence?

NRPs have to be differentiated according to the respective risks insured (ideally according to their expectancy value of claims/covered losses) -so risks with a higher expectancy value of losses will have higher NRPs while risks with lower expectancy value of losses will have lower NRPs -NRPs that are differentiated are aka "individual premiums" or "risk appropriate" premiums

What if NRPs are not differentiated?

NRPs that are not differentiated are aka "average premiums" or "general premiums" -so for all risks or a portfolio the same NRP is charged despite the fact that the risks have different expectancy values of claims/losses

what are some characteristics of money for indemnities as a production factor?

Nominal good: indemnities are paid in cash, and money is a nominal good Original/primary production factor: cash is obtained from outside Consumption factor: money is used up when indemnities are paid Potential factor: if money is stored for future payments of indemnities when the premium has already been paid

what is Excess of loss ratio reinsurance?

-aka stop-loss reinsurance -an excess of loss ratio insurance offers the ceding company protection against cumulative losses from a portfolio exceeding an agreed loss ratio in a financial year

What is the problem with a lack of structural neutrality as we see with non-individually risk equivalent NRPs?

-if we have a general premium and risks with different expectancy values, then each fluctuation or change in the portfolio (risks leaving and entering) will change the average NRP -and if the NRP is not adjusted, then there will be no equivalence of the expectancy value of total loss and total NRP

what are the three main differences between reinsurance and coinsurance?

-in reinsurance the reinsurer is only the contracting partner of the direct insurer (not the policy holder), whereas in co-insurance all co-insurers are contracting partners of the policy holder -in reinsurance the policy holder does not know whether the risk for which they have taken out insurance is being reinsured or not, whereas in co-insurance all co-insurers and their respective quotas are outlined in the insurance contract -in reinsurance the policy holder has no claim against the reinsurer in the case of damage/loss, whereas in coinsurance the policy holder has a claim against each coinsurer in the case of damage/loss

how can production factors be classified by way of provision?

-original/primary production factor: provided from outside market -derivative/secondary production factor: produced internally

how can production factors be classified by way of employment in the production process?

-potential factors: utilized over a longer period of time (ie machines/equipment) -consumption factors: used up in the production and are not available for further production processes

What are the two forms of proportional reinsurance?

-quota share reinsurance: a fixed proportion (%) of the risks/insured sum underwritten by the primary insurer is ceded to the reinsurer -surplus line reinsurance: only amounts of insured sums in excess of the primary insurers retention are ceded to the reinsurer--> the proportion therefore varies across risk

How can production factors be classified like other goods?

-real tangible goods (buildings, equip...) -real intangible goods (work performance, services...) -nominal goods (money)

What are the three cases of problems affecting the independence of risks?

-risk of cumulation -risk of contagion -risk of fluctuating basic probabilities

what is the benefit of stop loss reinsurance?

-the spread of outcomes (profits/losses) are reduced

What are the factors reducing the extent to which adverse selection takes place?

1. insurance conditions (terms of policy) may be hard for the customer to understand 2. there may be different products (coverage) with different prices 3. the customer may have strong preferences for an insurer or agent they are familiar with 4. insurance contracts may provide a multi-year period of contract during which the policyholder cannot switch to another insurer 5. bother the insurer and customer may not act rationally as regards to maximum utility

What are the three effects of experience rating?

1. part of the insurers technical risk is transferred from the insurer to the policy holders (since premiums are dependent on random claims/losses, fluctuation of losses for the insurer is reduced) 2. part of the loss is borne by the policyholder (retention, like a deductible)- each premium rise as a consequence of loss means that part of the loss is borne by the policy holder 3. premium differentiation

what comprises insurance business?

1. risk business 2. saving/dissaving business 3. service business

What are the two peculiarities of services production?

1. services have an inverse production function 2. the necessity of the contribution of the external factor

What is meant by the criteria "independence" in technical insurability?

as we know from the risk pooling and risk balancing risk process, insured risks should be independent of each other-- they should not be correlated -if too many risks are affected by damage/loss then there are too many negative differences (between individual expected and actual values of loss) to be offset by positive differences from risks which are not affected by damage.

why is it necessary to have the contribution of the external factor in services production?

because the production of a service requires the contribution of the customer -for example, hairdressing can only be done if the customer allows for their hair to be cut

Why are premiums calculated independently from the original premium in non-proportional reinsurance?

because the risk transferred from the primary insurer to the reinsurer has a probability distribution of its own which is different from that of the original risk

how can insurers protect themselves from the "manipulability" of risks?

by using deductibles in insurance contracts --> in certain lines of insurance he problematic behavior of the policyholder is being covered (for example liability insurance), deductibles help in this case

what is the credibility method of experience rating calculation?

here the NRP for a risk in a given period is a weighted composition of 1. the average NRP of the portfolio and 2. the individual loss experience of that risk in previous periods these two components are weighted by the credibility factor (z), expressing the "credibility" of the individual loss experience

What is the net risk premium?

ideally the net risk premium for an insured risk is equal to the expectancy value of losses covered

What is adverse selection?

if an insurer charges a general risk premium, then people with risks that have an expectancy value of loss lower than the NRP will leave or not sign on with the insurer while people with risks that have an expectancy value of loss higher than the NRP will sign on with the insurer. Now the insurer is left with an NRP that is lower than the expectancy value of losses and he has to raise the premium to restore equivalence of total premiums and total expectancy value of loss in the portfolio, now policy holders with expectancy values less than the general NRP will leave and again the insurer is left with "bad risks". the cycle continues and eventually no risks are insured with the insurer

what are the redistributive effects of a non-individually risk equivalent NRP?

if there is a general NRP then there will be some people paying too much in relation to the individual expectancy value of loss and others paying too little in relation to the individual expectancy value of loss -in other word people with "good risks" will be paying too high of a premium while others with "bad risks" will be paying too low of a premium -so policy holders with good risks become poorer and policy holders with bad risks become richer (in an ex ante view regarding only expectancy values)

what are some problems with primary premium differentiation?

in practice the ideal of risk equivalence of the NRP is hardly ever fully achieved by primary risk differentiation because; -there are limits to proving statistically the influence of factors relevant to the expected value of losses -there may be difficulties in recognizing relevant factors when underwriting a single risk (ie traits of a persons character) -relevant factors may not remain constant (ie changing drivers in car insurance) -aspects of efficiency: costs (of premium calculation/differentiation) and complexity (difficult to get a lot of necessary info- especially if you need to get it from the customer)

what is the product in risk business?

in risk business the product is risk transfer(s)--> the transfer of probability distributions of damage/loss -the insurer makes an "insurance protection promise" for a certain period of time. the promise is fulfilled after the occurrence of insured events through payment of indemnities -since payment only occurs if there is damage or loss, insurance is said to have a temporal dimension

how do you calculate the relative NRP in damage insurance?

relative NRP = (relative frequency of loss)(relative average loss)

how do services have an inverse production function?

services cannot be stored and cannot be produced for an anonymous market, they have to be sold first and only after the sale of the service can its production take place, employing the necessary, respective production factors

what is the production function?

shows the quantitative connection between input and output (or product and production factors)

What is proportional reinsurance?

sums insured (risks) are divided between the primary insurer and the reinsurer and premiums and losses are then divided accordingly (proportionately) -the reinsurer here offers coverage for an agreed proportion of losses -includes quota share reinsurance and surplus line reinsurance

What is capital investment business?

the capital investment business is linked to the insurance business because there are financial funds for three reasons: 1. prepayment of premiums (money from premiums) 2. risk reserves (money set aside to cover future losses) 3. saving/dissaving process (money from interest) -these funds can or have to be invested

how does experience rating lack selectivity?

the objective of experience rating is to assign higher premiums to risks with a higher expectancy value of loss and lower premiums to risks with lower expectation values of loss however, only events of damage are observable and it may be the case that by chance risks with a higher expectancy value of loss are lucky and remain without loss in the observation period, while risks with a lower expectation value of loss have a period of high loss

What happens if one co-insurer cannot pay their part of the loss?

the policy holder has a claim over the insurer

What is excess of loss reinsurance on an occurrence basis?

the reinsurer offers cover for all losses combined from an event and exceeding an agreed amount of loss -offers protection in the event of an accumulation of losses

What is excess of loss reinsurance on a risk basis?

the reinsurer offers cover for all losses from a single risk exceeding an agreed amount of loss -lets say the reinsurer covers losses in excess of 15 to a max of 40 paid in total. for any loss less than 15 the primary insurer will retain it all. The reinsurer will cover any losses above 15 with max coverage of 40

what is service business?

the services rendered by the insurer from their risk business and saving/dissaving business: -counseling of customers, actual transactions in risk business in the sales process, handling the contract policy, claim settlement

what is the risk of contagion?

the situation that the probability of damage/loss with one insured risk will increase if a damage with another risk occurs -for example when there is a contagious disease or on fire insurance when buildings are close to each other

What is meant by the criteria "size" in technical insurability?

the size of a risk should not be too different from the average size of risks in the portfolio -for example, it is a problem if the liability risk of running a nuclear power plant (big risk) is pooled with household insurance (little risk)

What is the product in insurance business?

the whole insurance product "insurance protection over a period of time" comprises: -risk business -service business -saving/dissaving business (in some cases)

What is the purpose of Facultative obligatory reinsurance?

this enables the primary insurer to underwrite certain types of risks in direct business knowing that there will be reinsurance cover available without asking the reinsurer before

what is risk business?

this is the core of the insurance business: risk transfer and risk transformation by the risk balancing process

What is reinsurance?

through reinsurance the primary insurer transfers risk onto a reinsurer for part of the premium that the policy holder paid

where does the value of production factors come from?

value of production factors results from; -scarcity (availability of the product) -utility (the contribution of the product in the production process)

What is the empirical/practical approach to insurability?

we look at the insurance market at which risk are actually underwritten and which are generally not, and also at which risks are underwritten by certain insurers but not by others

What is primary premium differentiation?

when NRPs are differentiated at the beginning of insurance contracts with regard to the respective features of the risks underwritten (ie age of someone getting life insurance)

what is secondary premium differentiation?

when NRPs are differentiated in hindsight according to the individual claim/loss experience of the risks insured (ie experience rating)

what is substitutional production function?

when a certain output can be produced with different quantitative relations of product factor categories -for example a pit can be excavated using 5 machines and no workers OR 3 machines and 400 workers OR no machines and 1000 workers

what is limitational production function?

when a certain output can only be produced with a certain quantitative relation of product factor categories -for example a car can only be produced with 1 motor, 1 steering wheel and 4 tires NOT 2 motors, 5 steering wheels and 3 tires

What is the theoretical/technical approach to insurability?

when criteria are applied to help assess the insurability of risks

what is the inverse production function?

when input is dependent on output -usually the case in services production I = f(o)

What is surplus line reinsurance?

when only amounts of insured sums in excess of the primary insurers retention are ceded to the reinsurer-- the proportion therefore varies across risk -say the primary insurer has a retention limit of 50 and for a certain risk the sum insured is 75. then for any losses from that risk the primary reinsurer will retain 2/3 (50/75) of it while the reinsurer will bear 1/3 of the loss. if for another risk the sum insured is 50 (or anything less), then the primary insurer will bear all of the loss

what is the normal production function?

when output is dependent on input -usually the case in industrial manufacturing o = f(I)

What is structural neutrality?

when the NRP is independent from the structure of the portfolio -this is one of the advantages of an individually risk equivalent NRP

what is the principle of individual risk equivalence of NRP?

when the net risk premium is equivalent to the expectancy value of losses covered NRP = E(x)

What is facultative Reinsurance?

when the primary insurer decides whether or not to take out reinsurance for a risk and the reinsurers decides whether or not to assume the risk if it is offered

What is co-insurance?

when two or more direct insurers underwrite a risk and each of these co-insurers bears only part of the risk (and losses) according to his quota *co-insurance is direct insurance

What is the risk of fluctuating basic probabilities?

with some damaging events (ie windstorms) we can observe that the probability of damage general fluctuates across different periods -for example there are years with less windstorm events than others --> such lines of insurance are therefore especially suited to be handled by the risk balancing process over time

what are the relevant factors in an insurer's decision to write a risk?

- the insurers objectives and attitude towards risk -the insurers situation (especially factors of production) such as the already existing pool of risks, availability of reinsurance, personnel, and other resources -the premium obtainable -aspects of the risk in question

What is non-proportional reinsurance?

-aka excess of loss reinsurance -when possible losses are divided between the primary insurer and the reinsurer in the first place -the reinsurer here offers coverage for losses exceeding an agreed amount of loss

what are some characteristics of the product "insurance as a risk transfer" in risk business?

-intangible product (represented legally by a contract and actually by information) -not storable -cannot be produced for an anonymous market (must be sold first)

What are the three ways non-proportional reinsurance (excess of loss reinsurance) can be done?

-on risk basis -on occurrence basis -loss ratio reinsurance

what are the criteria used in the theoretical/technical approach to insurability?

-randomness -unambiguousness -size -ratability -independence

Who are the parties involved in reinsurance?

Policy holder: transfers risk and premium onto the primary insurer (through direct insurance) Primary Insurer: the ceding company, can pass on risks he has underwritten to a reinsurer for a part f the premium that was received from the policy holder (reinsurance Reinsurer: is only the contracting partner of the primary insurer

Explain the credibility method over a period of time.

When the insurer underwrites a risk he has no loss experience regarding this particular risk so there is no respective "credibility", therefore z=0 and the insurer charges solely the average premium of the portfolio in the first period -in time the insurer gains experience and so he can raise the credibility rating so that the NRP is a composition of both average NRP of the portfolio and individual loss experience in previous periods -eventually after many periods the insurer may consider loss experience regarding risk sufficient enough to use it solely for premium calculation and the credibility factor is then raised to z=1

what is the net premium?

aka gross risk premium or risk premium -it is the net risk premium for an insured risk, plus the safety loading

What is umbrella cover?

an excess of loss reinsurance on occurrence basis which comprises more than one line of insurance -for example: umbrella coverage in a windstorm- reinsurance offering cover for the ceding company's losses (resulting from one windstorm event) from life insurance personal accident insurance, insurance for buildings, vehicles, etc.

How may NRPs be calculated in primary premium differentiation?

in practice, an NRP for a certain type of risk is calculated on the basis of statistical damage/loss records provided that all the risks considered are homogenous, then an NRP can be calculated from; -relative loss frequencies and sums insured (sum insurance) -average amounts of loss (in damage insurance)

what is made possible through retrocession?

risks can be transferred worldwide which helps reduce the impact of major loss in the event of a crisis

to what extent does adverse selection take place?

the extent to which adverse selection takes place is dependent on the extent to which criteria of the perfect market are fulfilled; 1. complete market transparency 2. homogeneity of products 3. no customer preferences towards insurer or agents 4. infinite speed of reaction 5. suppliers and customers strive for maximum utility

what is production theory?

the process of converting inputs into outputs or production factors into products input --> transformation --> output

What is insurability in a decision making context approach to insurability?

this approach tries to identify the relevant factors for an insurers decision to write a risk

What is secondary premium differentiation?

when NRP is calculated in hindsight according to the individual loss record of the risks insured

What are the three different businesses of an insurance corporation?

1. insurance business 2. capital investment business 3. other business

What is experience rating?

- a form of secondary premium differentiation -comprises all methods of premium calculation where the NRP is totally or partially dependent on the record of individual actual losses of a single risk insured

What are the four categories of production factor classification?

1. classification like other goods 2. classification by the way of provision (from where it is provided?) 3. classification by way of employment in the production process (is it used for long periods of time or just once?) 4. classification by the scope of employment in the production process (is it used to make many different goods or just one?)

What are the different approaches that can be used to answer the question of insurability?

1. empirical/practical insurability 2. theoretical/technical insurability 3. insurability in a decision making context

What are the two problems of experience rating?

1. experience rating is only functional with high frequencies of losses 2. lacks selectivity

in stop loss reinsurance how do you calculate what is paid by the reinsurer and the primary insurer?

[actual loss ratio - stop loss limit = payment by reinsurer] [actual loss ratio - payment by reinsurer - admin costs - reinsurance premium = costs for primary insurer]

What is the problem with non-individually risk-equivalent NRPs?

a deviation from the equivalence principle may result in: 1. adverse selection 2. lack of structural neutrality 3. redistributive effects and cross-subsidy between policy holders

What is quota share reinsurance?

a fixed proportion of the risks underwritten by the primary insurer is ceded to the reinsurer -the sums insured are divided up in the first place between the primary insurer and the reinsurer (say 40% of loss is retained while 60% is passed on to the reinsurer). when there is a loss then the primary insurer bears 40% of the loss and the reinsurer bears 60% of the loss

What is the pure method of experience rating calculation?

a simple, pure method for experience rating makes the NRP dependent of the average losses of previous periods NRP(abs) = (sum of losses over given periods)(number of periods) NRP(rel) = (sum of losses over given period)/(sum of sums insured over given period)

What is obligatory reinsurance?

a treaty between the primary insurer and the reinsurer in which the primary insurer is bound to submit all risks (of a certain type) to the reinsurer and the reinsurer is bound to assume these submitted risks