Fin 3040 exam 1
Non insurance transfers
A risk may be transferred to another party by several methods: A transfer of risk by contract, such as through a service contract or a hold-harmless clause in a contract. The risk of a defective flat screen tv can be shifted to the retailer by the purchase of a service contract by which the retailer is responsible for all repairs after the warranty expires.
Static risk
FROM UNCHANGING SOCIETY Ex: Pure - random events; lightning, windstorm, death
Natural Perils - Generally Difficult to Insure:
Flood Earthquake Epidemic Volcanic eruption Mold
Risk Managers have several sources of information to identify loss exposures:
Questionnaires Physical inspection Flowcharts Financial statements Historical loss data Industry trends and market changes can create new loss exposures. e.g., exposure to acts of terrorism
Types of Government insurance
Social Insurance Programs Financed entirely or in large part by contributions from employers and/or employees Benefits are heavily weighted in favor of low-income groups Eligibility and benefits are prescribed by statute Examples: Social Security, Unemployment, Workers Comp
The risk manager of a paint company wants to know more about the employee injuries. One loss was a wrist sprain that has a probability of .06. Another has a back sprain with a probability of .07. Yet another was over inhalation of a hazardous substance with a probability of .02. The other two losses were slips and falls with a probability of .13. If the amount of losses were $700, $3000, $2500, & $950, respectively, what is the expected value of an employee injury loss for that year?
$549.00
Standard deviation
(amount of loss-expected value) squared X probability
Binomial distribution
Requires discrete variables (loss or no loss) Small number exposures
Particular risk
Risk that affects only the individual and not the entire community or country Ex.: car thefts, bank robberies, dwelling fires (affects only individuals)
Risk
Uncertainty concerning the occurrence of a loss
Poisson Distribution
Use if exposure units are over 50 and probability of loss is very small
Human Perils - Generally Difficult to Insure:
War Radioactive contamination Civil unrest Terrorism
What is Underwriting Risk?
When an insurance company increases the size of the sample insured, underwriting risk (maximum insured loss) increase because more insured exposure units could suffer a loss. = # of units insured x standard error of the avg. loss distribution
Natural Perils - Generally Insurable:
Windstorm Lightning Natural combustion Heart attack
Hazard
a condition that increases the chance of loss due to a peril
Balance Sheet
a summary of what a company owns (assets) and what it owes (liabilities) Total Assets = Total Liabilities + Owners' Equity
Property insurance
indemnifies property owners against the loss or damage of real or personal property
Pooling
involves spreading losses incurred by the few over the entire group
Direct loss
is a financial loss that results from the physical damage, destruction, or theft of the property, such as fire damage to a home
Non-insurance transfer
is a method other than insurance by which a pure risk and its potential financial consequences are transferred to another party Examples: Contracts, leases, hold-harmless agreements
Self Insurance
is a special form of planned retention by which part or all of a given loss exposure is retained by the firm.
Hedging
is a technique for transferring the risk of unfavorable price fluctuations to a speculator by purchasing and selling futures contracts on an organized exchange
captive insurer
is an insurer owned by a parent firm for the purpose of insuring the parent firm's loss exposures.
Association or group captive
is an insurer owned by several parents; ex. Members of a trade association
Insurance
is appropriate for loss exposures that have a low probability of loss but for which the severity of loss is high
Moral Hazard
is dishonesty or character defects in an individual, that increase the chance of loss Ex: faking accidents, inflating claim amounts
Speculative risk
is one in which both profit or loss are possible Example: business ventures; investments
Pure risk
is one in which there are only the possibilities of loss or no loss Example: premature death
fortuitous loss
is one that is unforeseen, unexpected, and occur as a result of chance
Pure captive
is owned by only one parent such as a corp.
Policyholders' surplus
is the difference between an insurance company's assets and liabilities The stronger a company's surplus position, the greater is the security for its policyholders Assets - Liabilities = Surplus
Subjective probability
is the individual's personal estimate of the chance of loss A person's perception of the chance of loss may differ from the objective probability
Adverse selection
is the tendency of persons with a higher-than-average chance of loss to seek insurance at standard rates
Indirect loss
results indirectly from the occurrence of a direct physical damage or theft loss, such as the additional living expenses after a fire to a home
Peril
specific contingency that may cause a loss
income and expense statement
summarizes revenues and expenses paid over a specified period of time The two principal sources of revenue are premiums and investment income
Expenses include
the cost of adjusting claims, paying the insured losses that occurred, commissions to agents, premium taxes, and general insurance expenses
According to the Law of Large numbers
the greater the number of exposures, the more closely will the actual results approach the probable results that are expected from an infinite number of exposures.
The higher the standard deviation
the greater uncertainty of loss
Subjective risk
uncertainty based on a person's mental condition or state of mind Two persons in the same situation may have different perceptions of risk Difficult to measure
In a "hard" market
when profitability is declining, underwriting standards are tightened, premiums increase, and insurance becomes more difficult to obtain
In a "soft" market
when profitability is improving, standards are loosened, premiums decline, and insurance become easier to obtain
Risk Transfer
A pure risk is transferred from the insured to the insurer, who typically is in a stronger financial position
Normal distribution
More versatile More realistic Small number exposures
Binomial Distribution
Only two possible outcomes exist: Loss or No Loss n x p = mean The standard deviation of a distribution is a measure of risk or dispersion. For a binomial distribution, the standard deviation is √(𝑛 𝑥 𝑝 𝑥 𝑞)
Dynamic risk
PRODUCED BY CHANGES IN SOCIETY Ex: Increasingly complex technology, change in legislation due to changes in attitudes
Private insurance coverages can be grouped into two major categories
1. Personal lines 2. Commercial lines
Risk Management Process
-Identify potential losses -Measure and analyze the loss exposures -Select the appropriate combination of techniques for treating the loss exposures -Implement and monitor the risk management program
Characteristics of an Ideally Insurable Risk
-Large number of exposure units -Accidental and unintentional loss -Determinable and measurable loss -No catastrophic loss -Calculable chance of loss -Economically feasible premium
Basic Characteristics of Insurance
-Pooling of losses -Payment of fortuitous losses -Risk Transfer -Indemnification
Adverse selection can be controlled by:
-careful underwriting (selection and classification of applicants for insurance) -policy provisions (e.g., suicide clause in life insurance)
How to Recession Proof yourself?
1. $1000 to start an emergency fund. 2. Pay off all debt using the Debt Snowball 3. 3 to 6 months of living expenses in savings 4. Invest 15% of pre tax household income into Roth IRAs and/or pre-tax retirement such as 401k 5. College funding for children 6. Pay off home early 7. Build wealth and give (invest in mutual funds and real estate) (Insurance is infused in all of the steps not a specific step)
Techniques for Managing Risk
1. Avoidance 2. Loss control 3. Retention 4. Non-insurance transfers 5. Insurance
Normal Probability distribution
68% of all losses will be within 1 standard deviation of the mean 95% of all losses will be within 2 standard deviations of the mean 99% of all losses will be within 3 standard deviations of the mean More realistic More useful Can be employed in more situations
Avoidance
A drug manufacturer can avoid producing a dangerous drug that may result in a lawsuit.
Fundamental risk
Affects the entire economy or large number of persons or groups within the economy Ex.: Hurricane Katrina-largest single catastrophe in U.S. history (property damage exceeded Sept. 11, 2001)
Expected value
Amount of loss X Probability of loss
Retention
An individual or firm retains all or part of a given risk.
Loss exposure
Any situation or circumstance in which a loss is possible, regardless of whether a loss occurs.
Methods for Treating the Loss Exposures
Avoidance Retention Noninsurance transfers Loss Control Insurance
Assume the riskiness of a company is under consideration by an insurance company. This company anticipates incurring 20% losses within a specified period, such as a year. This company's exposure units are 3,000. What is the standard deviation of this distribution if there are only two possible outcomes: loss or no loss? What is this distribution called?
Binomial Distribution: n x p = mean Standard deviation = square root of n x p x q (Remember q = 1-p); q = .80 here √(3000 𝑥 .20 𝑥 .80)= √480=21.909 What is the coefficient of variation of this company's possible losses? Standard deviation/mean = 21.909/600 = .0365
A loss reserve is an estimated amount for:
Claims reported and adjusted but not yet paid Claims reported and filed, but not yet adjusted Claims incurred but not yet reported to the company
Measure and Analyze loss exposures
Estimate the frequency and severity of loss for each type of loss exposure Once loss exposures are analyzed, they can be ranked according to their relative importance
Insurance
For most people, insurance is the most practical method for handling a major risk Ex: An automobile insurance policy can be purchased covering the negligent operation of an automobile.
Other Government insurance programs
Found at both the federal and state level Examples:Federal flood insurance, state health insurance pools
Uncertainty
If the probability of an event occurring is either zero or one, there is no risk since there is no
The presence of risk results in three major burdens on society:
In the absence of insurance, individuals would have to maintain large emergency funds The risk of a liability lawsuit may discourage innovation, depriving society of certain goods and services Risk causes worry and fear
Soft market
Insurance companies lower premiums More "liberal" underwriting Investment earnings exceed underwriting losses Deductibles are lower and contract terms are more attractive ex-life insurance
Hard market
Insurance companies raise their premiums or less coverage for the same premium More "conservative" in their underwriting Restricted contract provisions September 11 resulted in a hard market (large losses & bad investment returns ex-director's & officer's liability insurance
Types of Private insurance
Life, health, property, Liability, causality
The central limit theorem
The distribution of the sample mean will approach the normal distribution as the sample size increases
Indemnification
The insured is restored to his or her approximate financial position prior to the occurrence of the loss
Loss severity is more important than loss frequency:
The maximum possible loss is the worst loss that could happen to the firm during its lifetime The probable maximum loss is the worst loss that is likely to happen
Captives are formed for several reasons, including:
The parent firm may have difficulty obtaining insurance To take advantage of a favorable regulatory environment Costs may be lower than purchasing commercial insurance Easier access to a reinsurer Profit center Premiums paid to a captive may be tax-deductible under certain conditions
Chance of loss
The probability that an event will occur
Human Perils - Generally Insurable:
Theft -E-commerce Vandalism Hunting accident Negligence Fire & smoke
Consequential loss
These additional expenses would be
Case reserves
are loss reserves that are established for each individual claim
Physical Hazard
are physical conditions that increase the chance of loss Ex: icy roads, defective wiring
Morale Hazard
carelessness or indifference to a loss, which increases the frequency or severity of a loss Ex: leaving keys in an unlocked car
Loss Control
certain activities are undertaken to reduce both the frequency & severity of losses
Enterprise risk management
combines into a single unified treatment program all major risks faced by the firm: Pure risk Speculative risk Strategic risk Operational risk Financial risk
Commercial lines
coverages for business firms, nonprofit organizations, and government agencies
Personal lines
coverages that insure the real estate and personal property of individuals and families or provide protection against legal liability
Health insurance
covers medical expenses because of sickness or injury
Liability insurance
covers the insured's legal liability arising out of property damage or bodily injury to others
Enterprise risk
encompasses all major risks faced by a business firm, which include: pure risk, speculative risk, strategic risk, operational risk, and financial risk
Avoidance
means a certain loss exposure is never acquired, or an existing loss exposure is abandoned The chance of loss is reduced to zero It is not always possible to avoid all losses Ex. Paint factory stops producing paint to avoid losses; will no longer be in business
Passive retention
means risks may be unknowingly retained because of ignorance, indifference, or laziness.
Active retention
means that an individual is consciously aware of the risk and deliberately plans to retain all or part of it. Ex. An individual may retain the first $500 of physical damage to his auto by purchasing an automobile collision policy with a $500 deductible.
Retention
means that the firm retains part or all of the losses that can result from a given loss Retention is effectively used when: No other method of treatment is available The worst possible loss is not serious Losses are highly predictable
Incorporation
of a business firm transfers to the creditors the risk of having insufficient assets to pay business debts
Life insurance
pays death benefits to beneficiaries when the insured dies
Insurance is the
pooling of fortuitous losses by transfer of such risks to insurers, who agree to indemnify insureds for such losses, to provide other pecuniary benefits on their occurrence, or to render services connected with the risk
Loss prevention
refers to activities to reduce the frequency of losses
Loss reduction
refers to activities to reduce the severity of losses
Causality insurance
refers to insurance that covers whatever is not covered by fire, marine, and life insurance
Objective probability
refers to the long-run relative frequency of an event assuming an infinite number of observations and no change in the underlying conditions
Financial risk
refers to the uncertainty of loss because of adverse changes in commodity prices, interest rates, foreign exchange rates, and the value of money.
Objective risk
relative variation of actual loss from expected loss Measurable, statistical If a loss is certain to occur, objective risk is zero.
