1-D Hazards and Risk

1.9 Loss

1. Reduction in value of an insured item 2. Financial loss due to an occurrence or accident 3. For insurers: the amount paid out in a claim settlement For example... Dan lost control of his car, hit a tree and wrecked the car, breaking his wrist in the accident. The car is a loss because its value is reduced. Dan's medical bills are also a loss. He is insured for collision damage and has Medical Payments coverage. His insurer indemnifies Dan to replace the car and pay for his medical bills. The insurer considers the amount paid to be its loss. Loss #1: reduction in value of Dan's car after accident Loss #2: medical bills for Dan's injured wrist Loss #3: what the insurer has to pay Dan for his property damage and injury

1.7 Hazard

A condition increasing the likelihood or severity of a loss Hazard vs. Exposure: ● Exposure is the possibility of loss ● Hazards are things that increase that possibility ● More Hazards = Higher Exposure For example... ● Storing explosives in a basement creates a hazard by increasing the chance of an explosion. ● Having a hot tub in your house could be a hazard that increases the exposure to damage or liability. ● Flammable liquids stored in a closet are a hazard. The hazard increases the house's exposure to fire.

2.8 Law of Large Numbers

A large number of insured units reduces the possibility of variation from the expected number of claims. If there are more units involved, there will be much less variation from statistics, which means the rate of claims will be more predictable. For example... We could say that on average, ten percent of all cars are stolen every year. If an insurer issued policies for only ten cars and one car (10% of ten cars) was stolen, the insurer would probably break even. But, as with all statistics, there is always the possibility of running into the occasional outlier or exception to the rule. What if, by a stroke of bad luck, two cars out of the ten were stolen, instead of just one? In this case the insurer would face significant loss. The situation changes, however, when 100,000 cars are insured. If ten percent of those cars are expected to be stolen, that would mean 10,000 car thefts. And, since the number of insured cars is so large, the occasional variation from the standard won't have much of an impact. In fact, the odds of there being more than 10,200 thefts fall to only one percent.

2.7 Law of Large Numbers

A large number of similar risks must be insured. ● Spreads the risk across more policies ● Helps the insurer predict losses more accurately ● "Similar risks" can mean: cars, houses, persons' lives, similar businesses, etc.

1.6 Evaluating Exposure

Exposure ● Expressed in dollars or units ● A determining factor in issuing a policy and setting a premium. For example... Sue wants to insure her house, which is built near a cliff. The underwriter would research the area to find out its history of mudslides before writing the policy. The insurer will find what the exposure has been for this area before issuing a policy and setting the premium. We say a risk might be open or exposed to l

1.5 Exposure

Exposure The extent to which a person, item, or organization is open to damage or loss Insurers consider a risk's exposure when deciding whether or not to insure it. For example... A house built on the Gulf coast has high exposure to hurricane damage. A car whose owner lives on a high-crime street has high exposure to theft

1.11 Review: Important Terms

Exposure: the possibility or likelihood of damage or loss Hazard: anything that increases exposure Peril: the cause of damage or loss Loss: ● Reduction in value ● Expense caused by a covered peril ● The amount an insurer pays to settle a claim For example... Hazards are things that increase exposure, such as: ● Smoking ● Storing flammable materials ● Swimming pools ● Nearby rivers prone to flooding ● High crime neighborhoods A peril is anything that causes actual damage, such as: ● Lightning ● Hail ● Fire ● Vandals ● Hurricanes

2.5 Substantial Losses

The loss must cause substantial economic hardship. For example... If your shirt is ruined while you're barbecuing, you can easily buy a new one. This is not a substantial loss. If a guest accidentally backs his car into your porch, you can't easily afford a new porch. This is a substantial loss.

1.2 Risk: 2 meanings

The word "risk" has two meanings in the insurance industry: 1. The potential for financial loss; being exposed or open to damage 2. An insured item

2.9 Law of Large Numbers Example

Here is an easy way to visualize the law of large numbers. Statistically, when you flip a coin, the odds of getting heads or tails is 50/50. Now imagine you flipped a quarter ten times. The odds of getting exactly five heads and five tails are not good. However, if you flipped the quarter one thousand times, the ratio between head and tails will be much closer to 50/50, and the more times you flip, the closer it will get.

2.1 Insurable Risk

Insurable Risk ● Risk: an item, person, or organization that has been insured ● Not everything is insurable ● Six qualifications determine what can be insured For example... Suppose you were examining a claim for damage to a car and the claimant asked if he could be reimbursed for the loss of a family photo album destroyed in the accident. You might have to explain that although family pictures have great value to the owner, their loss would not cause serious financial hardship, whatever the emotional pain.

2.2 Adequate Premiums

Insurer must be able to cover claims with premium income ● Potential losses cannot be too much for the insurer to pay ● Insurer must be able to cover claims and expenses ● If premiums must be set too high, the risk is not insurable For example... Texas homeowners policies often exclude hurricane coverage. Why? Because catastrophic losses from hurricanes made it impossible to charge premiums high enough to cover claims and operating costs. The risk was simply too great. The Texas Windstorm Association was set up to provide state-subsidized hurricane coverage that private insurers would not insure on the open market.

2.11 Adverse Selection and the Spread of Risk

Problems with Adverse Selection ● Insufficient premiums for level of risk exposure ● Leads to higher premiums, which might cause people to cancel policies One solution: charging higher-risk individuals higher premiums

1.4 Pure Risk

Pure Risk: ● Risk with no chance of gain ● Only two possible results: 1) loss or 2) no loss ● No chance of gain ● Can be insured

2.12 Review: Insurable Risk

Qualifications for insurable risk: 1. Policy premiums can cover both claims and expenses. 2. The insurer can define the exact conditions under which the item is covered by the policy; if the item itself is definable; and if the item, person, or organization has clearly defined value. 3. The loss is unforeseeable, unexpected, and reasonably unpreventable. 4. The loss causes substantial economic hardship. 5. The insurer can exclude coverage for significant disasters and catastrophic events. 6. A large number of similar types of risk are insured.

1.3 Speculative Risk

Speculative Risk: ● Undertaken with no certainty of either gain or loss ● Made knowingly, by conscious choice ● Cannot be insured Insurers will not cover speculative risks

2.3 Definable Risk

The Risk must be definable: 1. The insurer can define the exact conditions under which the item is covered by the policy. Example: Jewelry is covered up to a specified limit if stolen. 2. The item itself is definable (it can be precisely described). Example: A house, car, or diamond necklace can be defined. An entire riverbed cannot. 3. The item has precise value. Example: A house or car does. A family photo does not. For example... If a car is damaged during a hailstorm, the policy under which a claim is made for the loss must clearly state whether such damage will be covered and what percentage of the loss it will pay. The year, make, model, mileage, and condition of the car must be known so that its value can be determined. Only items whose parameters can be exactly defined by description and value are insurable.

1.8 Peril

The actual cause of loss or damage Insurance Policies can be: ● Named Peril - lists each peril that is covered ● All Peril (Open Peril) - covers all perils except those specifically excluded For example... Lightning, fire, theft and flood are perils, because they are events you have no control over.

2.6 Exclusions

The insurer must be able to exclude coverage for large-scale disasters and catastrophic events. ● Insurers have to charge adequate premiums ● Some losses would require such large premiums that it is impossible to insure them For example... Since California earthquakes have caused hundreds of billions of dollars in damages, many insurers exclude coverage for this natural disaster. Wars, a nuclear missile attack, earthquakes, and floods are events so enormous in effect that revenue from premiums would almost certainly not cover claims expenses.

2.4 Unexpected Losses

The loss must be: ● Unforeseeable ● Unexpected ● Reasonably unpreventable ● Completely random in nature For example... If an insurer knew that your house was built in a floodplain, you could not expect to be accepted as that insurer's client. Why would anyone insure such a property? Both your loss and the insurer's would be likely. An insurer's business is to protect policyholders from unforeseen, catastrophic, unpreventable events.

1.10 Review: Risk

Two meanings of "Risk:" ● Potential of loss ● The insured item Two categories of Risk: ● Speculative = any risk in which gain is possible (not insurable) ● Pure risk = any risk in which no gain is possible (insurable) For example...Gambling, investing in businesses, or buying lottery tickets are speculative risks. For example... A driver with a drunk driving record is a pure risk (and a poor one). For insurers, cars, houses, boats, persons, businesses—anything that can lose or retain financial value—are pure risks.

2.10 Adverse Selection

When someone decides to buy insurance because he knows he will probably have to file a claim, typically because of information about the risk that the insurer is unaware of or unable to discriminate against For example... Because of the higher risks of disease and death associated with tobacco use, smokers may be more motivated to purchase health insurance than non-smokers. Another example would be the fact that healthy young people usually buy minimal health insurance to save money on their premiums, while high-risk people tend to choose more extensive coverage, since they know that they will most likely need to use the coverage.