An Introduction to Insurance and Risk Management

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Chapter 8

• An Introduction to Insurance and Risk Management

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Risk

• Uncertainty concerning the occurrence of loss
• Chance that (realized) outcomes differ
  significantly from what was expected
• Sometimes ascribed to the property or person
  being insured

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Understanding Risk

• Subjective vs. Objective Risk
• Loss vs. Risk
• Peril and Hazard
• Pure vs. Speculative Risk
• Law of Large Numbers

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Objective Risk

• Objective risk relative variation of actual
  loss from expected loss
• Ex Suppose 100 out of 10,000 (1) of insured
  houses are expected to burn
• Some years as few as 90, others as many as 110
• Variation of 10, or 10 (10/100)
• Variation divided by expected
• Declines as number of exposures increases
• Varies inversely w/ square root of of exposures

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Subjective Risk

• Uncertainty based on a persons mental condition
  or state of mind
• Differs among individuals

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Chance of Loss

• Probability that an event will occur
• Objective probability long-run relative
  frequency of an event based on assumptions
• Infinite number of observations
• No change in underlying conditions
• An expected value or mean

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Objective Probability

• Deductive reasoning deduced from logic
• Ex coin toss (1/2) roll of dice (1/6)
• Inductive reasoning based on observation rather
  than being logically deduced
• Ex probability a person will die before age 21
  cannot be determined logically, but rather from
  past mortality experience

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Loss v. Risk

• Chance of loss is simply the probability that a
  loss will occur
• Objective risk is the relative variation of
  actual from expected loss
• Ex Insuring 10,000 homes in LA and Phily against
  fire
• Chance of loss may be 1 in each city (on avg.100
  homes burn)
• LA 90 to 110 Phily 75 to 125
• Objective risk greater in Philadelphia

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Peril Hazard

• Peril the cause of loss
• Fire
• Collision
• Earthquakes
• Tornadoes
• Hurricanes
• Theft, burglary

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Peril Hazard

• Hazard condition that creates or increases
  chance of loss
• Physical hazard
• Icy roads
• Defective wiring
• Defective lock
• Moral hazard dishonesty or character defect
• Fraudulent claim
• Inflating amount of damage

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Peril Hazard

• Morale hazard carelessness or indifference as a
  result of insurance
• Driving faster or more carelessly
• Leaving keys in an unlocked car
• Leaving doors unlocked
• Do not confuse Peril, Hazard, Risk
• Peril is the cause of loss, hazard makes it more
  likely, and risk is the variation in actual
  losses around expected losses

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Pure Risk v. Speculative Risk

• Pure Risk a situation in which there are only
  the possibilities of loss or no loss
• Premature death
• Accidents
• Property damage from fire, tornado, etc.
• Speculative Risk situation in which either a
  profit or loss is possible
• Stock investment, horse races, starting a business

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Pure Risk v. Speculative Risk

• Private insurers generally only insure pure risks
• The law of large numbers can be applied more
  easily to pure risk (except gambling)
• Society may benefit from a speculative risk, but
  is harmed by the loss from a pure risk

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Insurance

• 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 to the risk

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What is Insurance?

• Transfer of Losses
• Sharing of Losses with Others

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Insurance Characteristics

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

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Pooling of Losses

• Spreading of losses incurred by the few over the
  entire group
• Grouping of a large number of exposure units so
  that law of large numbers can work to improve
  prediction (reduce risk) of future losses

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Loss Spreading Example

• Assume 1,000 individuals each have homes worth
  100,000
• On average, 1 home burns per year
• W/O Insurance max loss 100,000
• Suppose all agree to share the loss (insurance) ?
  average loss 100,000 / 1,000 100
• Trading 100 loss for sure for chance of losing
  100,000 (See Expected Utility notes)

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Law of Large Numbers

• As number of exposures is increased, the more
  closely will actual results approach the probable
  results expected from an infinite number of
  exposures
• Example Flip a coin 10 times might get 8 heads
• Flip a coin 1,000,000 times, will get very close
  to 500,000 (actually, close to 50)

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Payment of Fortuitous Losses

• Fortuitous Loss one that is unforeseen and
  occurs as a result of chance
• Loss must be accidental
• Law of large numbers based on assumption that
  losses are accidental and random (not correlated)

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Risk Transfer

• A pure risk is transferred from the insured to
  the insurer
• Insurer is typically in a stronger financial
  condition to pay the loss
• Premature death, poor health, disability, theft,
  liability
• Self-insurance no risk transfer (risk retention)

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Indemnification

• The insured is restored to his or her approximate
  financial condition prior to occurrence of the
  loss
• Fire insurance meant to restore to original
  position

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Insurable Risk

• Large number of exposure units
• Loss must be accidental and unintentional
• Loss must be determinable measurable
• Loss should not be catastrophic
• Chance of loss should be calculable
• Premium must be economically feasible

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Insurable Risk

• Large number of exposure units
• Roughly similar, subject to same perils, and
  preferably independent of each other
• Allows for predictability based on the law of
  large numbers
• Loss must be accidental and unintentional
• Moral hazard problem
• Law of large numbers depends on randomness

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Insurable Risk

• Loss must be determinable measurable
• Should be definite as to
• Cause
• Time
• Place
• Amount
• Disability is difficult to determine and measure

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Insurable Risk

• Loss should not be catastrophic
• Large number of units should not incur loss at
  same time
• Pooling breaks down premiums become prohibitive
• Insurers use reinsurance
• Selling the risk to another insurer
• Spread coverage over larger geographical area

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Insurable Risk

• Chance of loss should be calculable
• Insurer should be able to calculate average
• Frequency of loss
• Severity of loss
• Floods, wars, unemployment difficult
• Premiums should be economically feasible
• Should be much less than face of policy
• Chance of loss should be relatively low

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Insurable Risk

• Personal, property and liability risks can be
  insured because requirements are met, generally
• Market, financial and political risks are not
• Speculative
• Potential for catastrophic loss too high
• Calculation of premium difficult
• Example Risks of fire and unemployment

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Adverse Selection

• Tendency of persons with higher than average
  chance of loss to seek insurance at average rates
• Controlled through underwriting
• The process of selecting, classifying and pricing
  applicants for insurance
• No problem if correctly priced

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Insurance v. Gambling

• Gambling creates a speculative risk
• Insurance is a technique for dealing with an
  existing risk
• With gambling there is a loser for every winner
  (no benefit to society)
• Both parties gain, on average, with insurance

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Insurance v. Hedging

• Both transfer risk no new risk created
• Insurance involves insurable risks hedging
  generally is used for uninsurable risks
• Insurance can reduce the the objective risk of
  the insurer through the law of large numbers
• Hedging does not involve risk reduction only
  risk transfer

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Elements of a Valid Contract

• Offer and Acceptance
• Legal Competency of all Parties
• Legal Consideration
• Lawful Purpose

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Legal Principles of the Insurance Contract

• The Principle of Indemnity
• The Principle of Insurable Interest
• The Principle of Utmost Good Faith
• Warranty
• Representation
• Concealment

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Distinguishing Characteristics of Insurance
Contracts

• Adhesion (Take it or Leave it)
• Aleatory (Unequal Money Exchange)
• Unilateral (Only One Promise, Made By Insurer)
• Conditional (Conditioned on Paying the Premium)

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Important Features of Insurance Contracts

• Exclusions
• Riders and Endorsements
• Valuation of Insured Losses
• Replacement Cost
• Actual Cash Value (ACV)
• Agreed-upon Value
• Deductibles and Co-payments
• Coinsurance

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Individual Loss Exposures and Insurance Coverages

• Perils that Can Reduce and/or Eliminate the
  Ability to Earn Income
• Dying too soon
• Living too long
• Accidents and illness
• Perils that Can Destroy or Deplete Existing
  Assets
• Damage to property
• Legal liability for injuries inflicted upon others

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Risk Management

• Identifying and Evaluating Pure Risks
• Selecting an Appropriate Risk Management Tool
• Risk Avoidance
• Loss Control
• Risk Retention or Assumption
• Risk Transfer
• Implementing and Reviewing the Risk Management
  Plan

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Evaluation of Potential Loss Frequency Severity

• Frequency probable number of losses that may
  occur over a period of time
• Severity probably size of the losses that may
  occur

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Appropriate Techniques

• Risk Control techniques that reduce the
  frequency and severity of losses
• Risk Financing techniques that provide for the
  funding of losses once they occur

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Risk Control

• Avoidance not acquiring a certain loss
  exposure, or abandoning an existing exposure
• Ex asbestos, childrens toys, alcohol at BOD
  meetings, riding motorcycles
• Disadvantages
• Cannot avoid all losses (premature death)
• Have to give up activities

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Risk Financing Retention / Transfer

• Retention retaining all or part of the loss
• Noninsurance risk transfers contractually
  transferring risk to others
• Commercial Insurance transfer through insurance

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Retention

• Active intentionally retain losses
• Passive unintentionally retain losses
• Necessary conditions for retention
• No other effective method available
• Worst possible loss is not serious
• Losses are highly predictable frequency and
  severity can be reasonably estimated

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Insurance

• Low probability (frequency) of loss but high
  severity
• Issues
• Selection of coverages
• Selection of insurer
• Negotiation of terms
• Dissemination of information
• Periodic review

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Insurance

• Coverage how much insurance and size of
  deductible
• Deductible amount paid (retained) by
  individual Used to
• Eliminate small claims admin. Expense of
  adjusting these claims
• Help solve the moral hazard proble

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Insurance

• Advantages
• Individual indemnified after loss.
• Uncertainty reduced (sleep factor).
• Claims services
• Disadvantages
• Premium cost Time and effort (pre post loss).
• Moral hazard.

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Risk Management Matrix