Class 2 Insurance and Risk Management

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Class 2Insurance and RiskManagement

• George D. Krempley
• Bus. Fin. 640
• Winter Quarter 2008

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Bus. Fin. 640 Website

• http//www.cob.ohio-state.edu/fin/winter2008/640.h
  tm

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Methods of Handling Risk

• Avoidance
• Loss control
• Retention
• Non-insurance transfers
• Insurance

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Risk Management Matrix
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Frequency

• Frequency measures the number of losses in a
  given period over the number of exposures to
  loss.
• If Sharon Steel Corp. had 10,000 employees in
  each of the last five years
• And, there were 1,500 injuries over the 5-year
  period
• Then, the loss frequency would be 0.03
  1500/50,000 employee-years.

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Severity

• Severity measures the magnitude of loss per
  occurrence.
• If the 1,500 injuries cost a total of 3,000,000
• Then, the expected severity of loss would be
  2,000.

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Expected Loss

• The Expected Loss is simply the product of the
  frequency and the severity
• Expected loss Frequency x Severity
• In our example, the Expected Loss equals 60
• 0.03 x 2,000 60
• Also known as the pure premium

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Definition of Insurance

• Pooling of fortuitous losses
• by transfer to an insurer,
• who agrees to indemnify insureds for such losses,
  and
• render services connected with the risk.

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Basic Characteristics of Insurance

• Pooling of losses
• Payment of fortuitous losses
• Risk transfer
• Indemnification

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Requirements of an Insurable Risk

• Large number of exposure units
• to predict average loss
• Accidental and unintentional loss
• to control moral hazard
• to assure randomness
• Determinable and measurable loss
• to facilitate loss adjustment
• No catastrophic loss
• to allow the pooling technique to work
• Calculable chance of loss
• to determine the premium need
• Economically feasible premium
• so people can afford to buy

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Risk of Fire as an Insurable Risk
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War - An Insurable Risk?
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Sample Quiz Question Chapter 2

• Which of the following is implied by the pooling
  of losses?
• sharing of losses by an entire group
• inability to predict losses with any degree of
  accuracy
• substitution of actual loss for average loss
• increase of objective risk

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Loss Exposure

• Set of circumstances that presents the
  possibility of loss, whether or not a loss
  actually occurs.
• Implies the existence of something that may
  decline in value
• The object and the circumstances can be
  objectively verified

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Elements of a Loss Exposure

• The item subject to loss
• The perils, or forces that may cause the loss
• The potential financial impact of the loss

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Exposure Analysis Restaurant Example
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Direct Losses often Cause Indirect Losses

• Example What are the direct and indirect losses
  if a manufacturing plant experiences a major
  fire?

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Law of Large Numbers

• The greater the number of exposures, the more
  closely will the actual result approach the
  expected result.

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EXHIBIT A2.1 Sampling Distribution Versus Sample
Size
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EXHIBIT A2.2 Standard Error of the Sampling
Distribution Versus Sample Size
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Definition Adverse Selection

• The tendency of persons with a higher-than-average
  chance of loss to seek insurance at standard
  (average) rates, which if not controlled by
  underwriting, results in higher-than-expected
  loss levels.

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Adverse Selection and Classification

• Adverse selection occurs when the insurer cannot
  classify, but the policyholders know their risk
• At a given price,
• high risk people will buy more coverage
• low risk will buy less coverage

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Deductibles and Adverse Selection

• Insurer offers multiple policies with different
  deductibles and different prices per dollar of
  coverage
• Lower deductible (higher coverage) policies have
  a higher price per dollar of coverage
• Higher risk people might choose the lower
  deductible (higher priced) policies
• Lower risk people might choose the higher
  deductible (lower priced) policies

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Deductibles and Adverse Selection

• Result applicants separate themselves into
  different policy groups
• Thereby, permitting the insurance company to
  classify and underwrite risks in a low-cost way

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Similar Purpose of Policy Limits

• People have limited amount of wealth they want to
  protect
• Reduce classification costs when consumers have
  information that is costly for insurers to obtain
• Example
• Homeowners policy might limit coverage for
  jewelry losses to 1,500
• Those with more expensive jewelry buy special
  coverage
• Insurer does not have to investigate the value of
  each policyholders jewelry

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Risk Management

• A process that identifies loss exposures faced by
  an organization or individual and selects the
  most appropriate techniques for treating such
  exposures.

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Risk Management Vs. Insurance

• Risk management is a decision process insurance
  is a method of risk transfer
• Risk management focuses on identifying and
  measuring risks to select the most appropriate
  technique.
• Insurance is only one of several options to treat
  pure loss exposures.

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Pre-loss Risk Management Objectives

• Economy
• Reduction in anxiety
• Meeting legal obligations.

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Post-loss Risk Management Objectives

• Survival of the firm
• Continued operation
• Stability of earnings
• Continued growth
• Social responsibility.

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Farm Breeze Case

• Post-loss Objectives of Founder
• Post-loss Objective of Vice President of Marketing

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EXHIBIT 3.1 Steps in the Risk Management Process
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Sample Quiz Question Chapter 3

• Risk management is concerned with
• the identification and treatment of loss
  exposures.
• the management of speculative risks only.
• the management of pure risks that are
  uninsurable.
• the purchase of insurance only.