Introduction to Risk Management and Insurance

1
Introduction to Risk Management and Insurance

• Finance Department of Shanghai University

2
1. Fundamentals Terminology

• Risks---Risk Management---Insurance
• Mathematical Foundation of Insurance---Law of
  Large Numbers
• Definition of Insurance
• Financial Definition---Redistribution
• Legal Definition---Contracts
• Others the Insurer, the Insured, a
  Premium, a Policy, the Insureds Exposure to
  Loss, Right Duty

3
Terminology

• Loss, Chance of Loss,
• Peril Hazard Moral Hazard, Morale Hazard
• Proximate Cause
• Insurable Loss Direct Losses Indirect Losses
• Pure Risk, Speculative Risk, Risk Management

4
Building Blocks of an Insurance Premium

• The Actual Cost of the Losses
• The Expenses of Operating and Maintaining the
  Insurance Pool
• An Allowance for Unexpected Losses, or the Risk
  Factor for the Insurance Pool
• Earnings on Investment
• An Insurance PremiumABC-D
• Sometimes an insurance premium can be priced
  below the level of expected losses.

5
2. Insurable Loss Exposures

• Not all potential losses are a good subject for
  insurance
• I. Ideal insurable loss exposure
• A large group of similar items exposed to the
  same peril.
• Accidental losses.
• Definite losses capable of causing economic
  hardship.
• Extremely low probability of a catastrophic loss
  to the insurance pool.

6
II. Risk Classification

• Subsidization
• Adverse Selection
• Principles of risk classification---fairness
• Separation and class homogeneity
• Reliability
• Incentive value
• Social acceptability

7
3. Risk Management

• The risk management is carried out by firms
  before they go to buy insurance. The purpose is
  to reduce the risks exposure.
• Risk Management Staff
• Head a manager with overall responsibility
• Insurance expert
• Claims manager
• Loss control engineer
• Employee benefits specialist
• Financial analyst

8
II. Statement of objectives and principles

• Objectives Survival, Growth, and Responsibility
• Principles Efficiency and Compliance
• Risk Management Manual
• General Guidelines
• Engage in loss prevention activities as if all
  chance of loss remained with the company
• Assume all risks that are not significant in
  relation to the companys financial strength
• Insure all risks not assumed

9
Example protecting the companys property
against fire and associated perils commitment to
loss control, good housekeeping, sprinklers,
adequate water supply, emergency organizations,
regular inspections

• There are three steps in risk management process
• III. Step One Identification and measurement of
  exposures
• Direct property losses
• Losses of income and extra expenses following a
  property loss
• Losses arising from lawsuits called liability
  losses

10
Losses caused by the death, disability, or
unplanned retirement of key people

• Estimation of maximum loss
• Emergency planningdisaster recovery
• IV. Step Two loss control and risk financing
• Loss control
• Risk avoidance
• Loss prevention
• Loss reduction

11
(2) Risk financing

• Risk assumption
• Self-insurance and financed risk retention
• Risk transfer other than insurance
• Insurance
• V. Step Three regular review of the risk
  management program

12
VI. Financial Risk Management

• Interest rate risk (swap)
• Credit risk (investigation)
• Currency risk (option, futures, forward)
• Liquidity risk (allowance)
• Market risk (hedging)

13
4. Private Insurance Companies

• I. Two different types of insurance companies
• Mutual insurance company
• Stock insurance company
• 1. Mutual insurance companies non-profit
• The owners are the policyholders insured by
  the corporation
• Advance premium mutual
• Assessment mutual
• Factory mutual

14

• 2. Stock insurance companies
• 3. Demutualization
• The conversion from mutual to stock insurance
  companies.

15
II. Lloyds of London one of the most important
insurance markets

• Established in 1688.
• In 1969 foreigners were allowed to become names
  of Lloyd.
• In 1990s Lloyds membership was 18,000
  individuals organized in about 170 syndicates.
• An individual needed a net worth of at least 250
  thousand pounds, with at least 150 thousand
  pounds in liquid assets, to become a name.
• III. Blue cross and Blue shield, HMOs and PPOs.

16
5. Insurance Occupation

• In recent years in the U.S., some 2.2 million
  people were employed in the insurance industry,
  among whom 1.5 million work in home offices and
  700,000 work as agents, brokers, or in service
  organizations.

17
I. Insurance agents brokers

• Insurance agent---the link between the insurance
  company and the insurance consumer.
• Duties of the agent
• Agency contracts specify the authorities to the
  agent.
• Agent should act within the limit of the
  authorities.
• Two other fundamental legal doctrines.

18
Insurance broker

• A broker is the agent of the insurance applicant.
• A broker is needed when the applicant wants to
  tailor out specific insurance requirements
• Licensing requirements
• Direct writers---employed by insurers
• Independent agents

19
II. Loss adjuster

• Employees, independent adjustment bureaus
• Public adjusters---an agent of the insured.
• reservation of rights
• waiver and estoppel
• III. Underwriter
• IV. Actuary

20
6.Insurance Regulation

• Regulation represents the rules by which the game
  is played.
• The government as market regulator to protect
  the weak group.

21
I. The reasons for insurance regulation

• Widespread severe impact of insurer insolvency
• Unequal knowledge and bargaining power of the
  buyer and seller
• Unique problem of insurance pricing
• Promotion of social goals

22
Promoting solvency the most important goal of
insurance regulation

• Unequal knowledge and bargaining power
• 1.lack of technical expertise on consumers side
• 2.deterioration of competition
• 3.complexity of insurance contract
• 4.insurance is an intangible good
• Prices insurers set prices before costs are
  fully known
• Promotion of social goals.

23
II. Regulated Activities

• Legal Reserve and Surplus
• Admitted Assets/Nonadmitted Assets
• Property Insurance Reserve Accounts unearned
  premium reserve/loss reserve
• Life Insurance Reserve Accounts increase with
  the passage of time
• Asset Valuation Reserve/Interest Maintenance
  Reserve

24
Regular Audits and Solvency Testing

• Audits by the state insurance department once
  every three years
• IRIS monitoring
• Risk-based capital as against minimum capital
  requirements
• Guaranty Funds
• Rate Regulations
• Investment Activities
• Policy Form Approval and Expense Limitations
• Qualifications or Licenses

25
7. Insurance Contracts

• Contract Valid, Voidable, Void
• Binder a temporary property insurance
  contract before the issuance of the formal
  insurance contract.
• Conditional Receipt a temporary life
  insurance contract when the applicants submit a
  premium payment.
• Difference between a binder and a
  conditional receipt the payment of the premium.

26
II. Elements of a valid contract

• Offer, Counteroffer, Acceptance
• Consideration exchangeable value---premium
  against contingent promises.
• Capacity minors, insane, intoxicated are
  incapable.
• Legal Purpose.

27
III. Insurance Contracts

• Principle of Indemnity
• Three exceptions to the rule life
  insurance, replacement-cost insurance, valued
  insurance policies
• Insurable Interest
• The insured should have a financial
  interest in the loss
• Property Insurance measured at the time of
  loss.
• More than one party owner, co-owner,
  mortgage
• Life Insurance measured at the time of
  purchasing the
• policy
• Close family relationships, creditor and
  debtor,
• close employment relations

28
Actual Cash Value

• Actual Cash ValueReplacement Cost-Depreciation
• Subrogation
• A is responsible for Bs loss. B can claim
  the loss from the insurer, and the company has
  the subrogation right to sue A.
• If it collects from A more than it
  compensates B, the balance belongs to B.
• An insurer has no right to subrogate
  against its own insureds.

29
Contract of Adhesion

• Any ambiguous language will be construed against
  the drafter of the contract
• Reasonable expectations misleading locations,
  unreasonable evidence
• The Personal Feature
• Assignment
• Property insurance transfer of rights
  duties with the consent of the insurer
• Life insurance change of beneficiary
• Assumption Reinsurance

30
Utmost Good Faith

• Warranty
• Representations answering questions
• Concealment
• IV. Discharge of Insurance Contracts

31
8. Rate of Premium

• Pure rate of premium premiuminsurance amount
• Rate of premiumpure rate of
  premiumX(1extra charge)
• II. Principle of the rate of premium
• Fairness
• Premiump.S
• p chance of loss,Sinsurance amount

32
Solvency avoid vicious competition

• Comparative stability
• Encouraging loss reduction
• III. Setting of property premium
• Rate of losscompensationinsurance amount
• Deviation usual 10 percent
• This is also the adjustment rate

33
Rate of property premium

• Rate of lossX(110)X(1g) (1y)
• g extra rate, y investment gain.
• IV. Rate of life premium
• FnP
• nnumber of payment years,
• Ppremium

34
9.Basic Property and Liability Insurance Contracts

• Commercial and personal property insurance
  policies have the following common elements
  declarations, insuring agreements, deductibles,
  definitions, exclusions, endorsements or riders,
  and conditions

35
Checklist to determine whether an insurer is
obligated to pay a claim

1. Is the property covered?
2. Is the person covered?
3. Is the loss caused by a covered peril?
4. Do any deductibles or exclusions apply to the
   loss?
5. Do policy conditions limit the amount of
   coverage?
6. Is the location of the loss covered?
7. Did the loss occur during a covered time period?

36
I. Standard Policy for most widely used property
liability insurance contracts

• II. Basic parts of an insurance policy
• Declarations
• Insuring Agreement
• Deductibles
• Definitions
• Exclusions
• Endorsements

37
III. Conditions

• Fraud
• Suspension of Coverage
• Cancellation
• Other Insurance
• Duties after a Loss
• Appraisal
• Salvage
• Claims Payment
• IV. Conclusion

38
10. The Personal Auto Policy

• The Auto Policy is an independent category of
  insurance
• The Personal Auto Policy (PAP) layout
• Declarations
• Named Insured
• Vehicles Covered
• Premium Charged

39
Insuring Agreements describe the insurance
in broad termsDefinitions

• II. Part A---Liability
• Limit of Liability
• Single Limit of Liability
• Split Limits
• Insureds
• Exclusions
• III. Part B---Medical Payments
• Reasonable expenses on a no-fault basis within 3
  years from the date of the accident

40
IV. Part C---Uninsured Motorist Coverage

• Purpose protect people from the loss of accident
  caused by another uninsured motorist
• Uninsured motorist
• Drivers without insurance
• Drivers with less insurance than the minimum
  required by the state law
• Hit-and run Drivers
• Drivers with coverage provided by insolvent
  insurers
• Contact or no-contact rules
• Underinsured motorists

41
V. Part D---Damage to Your Auto

• Collision
• Exclusions
• Other-than-collision Coverage
• Loss Settlement
• Actual Cash Value (ACV)
• VI. Part E---Duties after An Accident or Loss

42
VII. Part F---General Provisions

• Bankruptcy
• Fraud
• Compliance
• Subrogation
• Territory Covered

43
11. Commercial Property Insurance

• I. Commercial Insurance
• Business Firms Purchase Insurance
• II. Commercial Package Policy
• A package of policies providing insurance
  coverage to a broad range of organizations
• Components of CPP
• Common Declarations
• Common Conditions
• Commercial Property, Commercial General
  Liability, Crime, Inland Marine, Commercial Auto,
  Boiler, Farm, etc.

44
Insureds must purchase at least two of the
packages components, and as many as they need.

• III. Building and Personal Property Form
• Property Covered
• Building, Business Personal Property,
  Personal Property
• Property excluded from Coverage
• Perils Covered
• The Basic Form, The Broad Form, The Special
  Form
• Definition of Fire
• Hostile Fire, Friendly Fire
• Reporting Forms

45
Business Income Coverage

• Indirect Losses
• Business Income from Dependent Properties
• Additional Forms
• Property Insurance
• Rating Class Rating, Schedule Rating
• IV. Transportation Insurance
• Ocean Marine Insurance the origin of any
  insurance

46
Ocean Marine Coverages

• The Hull Exposure
• The Cargo Exposure Particular Average, General
  Average
• The Loss of Freight
• The Liability Loss Exposure
• The list of perils is very broad.
• Ocean Marine Insurance Rating
• Based on the judgment of the underwriters,
  includes
• The seaworthiness of the ship
• The experience and ability of captain and
  crew
• The potential for loss of the cargo
• The route and the season
• The coverage provided by the policy

47
V. Aviation Insurance

• Purchased by the owners and operators of
  aircraft, airport operators, and by companies
  building and supplying parts for aircraft, but
  not passengers.
• Including planes, helicopters, hot air balloons,
  hang gliders and space satellites.
• Aircraft owners purchase
• property insuranceaircraft hull
• liability insurance
• The core problem facing aviation insurers is the
  weakening of law of large numbers

48
Aircraft insurance premium a function of the
perils covered.

• VI. Automobile Property Insurance
• Commercial Auto Component provides both liability
  and property coverage.
• The commercial auto policy covers
• Medical Expenses drivers A and B and passengers
• Lost income and services drivers A, B and
  passengers
• Damage to automobiles A and B
• Additional property
• Ambulance expense
• Funeral expense
• Investigation expense
• Legal expense

49
The cause of the loss Collision or not
collision Collision Coverage
Comprehensive Coverage

• VII. Automobile Liability Insurance
• A. Liability Insurance The third-party insurance
  (The passengers in the auto are not the
  third-party)
• If As loss was caused by the negligence of B, A
  could sue B in a tort case. Bs insurer should
  compensate A according to the judgment, or settle
  with A without litigation.

50
B. No-Fault Automobile Insurance

• All parties receive compensation from their
  own insurer, regardless of who caused the
  accident.
• No-fault insurance is to speed the
  compensation in less serious traffic accidents.
• After some threshold of damage has been
  reached, the injured party may revert to the
  liability system to seek compensation.

51
C. No-Fault Vs. Tort Liability

• The shortcomings of tort liability
• Too small proportion of money used for
  compensation
• Unfair indemnity
• Slow recovery
• Difficult to prove negligence
• The supporting points to tort liability.
• The no-fault insurance provides one more option
  to the insureds so that it is more flexible.
• D. Commercial Automobile Insurance
• Business Auto Coverage Form
• Garage Coverage Form

52
12. Reinsurance

• One insurance company purchases insurance from
  other insurance companies.
• Primary insurer/ceding insurer
• Reinsurer
• Facultative reinsurance
• Treaty reinsurance/Automatic reinsurance
• I. Reinsurance Coverage
• Pro rata reinsurance
• Excess-of-loss reinsurance

53
The insured will most likely be unaware of any
reinsurance coverage agreement. It receives one
check in the event of a loss.

• II. Catastrophe Reinsurance
• Example total 100 million
• 5 million insured
• 10 million primary insurer
• 25 million first reinsurer
• 60 million catastrophe reinsurer

54
III. Reasons for Reinsurance

• Stability in operating results (enlarges
  financial strength)
• Reduction of size of the reserves
• Services provided by the reinsurer
• Improves relations between a company and its
  agents by accepting the large-sized exposures
• Allowing an insurer to profit without marketing a
  product to the public
• IV. For and against
• For spread the losses abroad
• Against not subject to the same level of
  regulation

55
V. Providers of Reinsurance

• Professional reinsurance companies
• Primary insurance companies
• Self-insurance subsidiaries of noninsurance
  companies
• International insurance firms
• A reinsurer can purchase reinsurance again
  retrocession

56
13. Life Insurance policies

• Broad meaning and narrow meaning
• Three distinct types of life insurance
• Life insurance
• Health insurance
• Annuities
• Life insurance has a savings function

57
I. Three ways life insurance is distributed

• Group life insurance
• Industrial or debit life insurance
• Individual life insurance
• Group Life Insurance
• Provided to a well-defined group of people who
  are associated for some purpose other than
  purchasing life insurance
• Generally costs less than similar individually
  purchased insurance
• Industrial Life Insurance small amounts

58
Individual Life Insurance also called ordinary
life insurance

• II. Term Insurance
• Insurer is to pay the beneficiary if the insured
  dies within a specified period
• Term insurance does not build savings or cash
  value
• Types of term life insurance
• Single-year term policies
• Five-year term policies
• Longer-term policies
• Term-to-a-specified age policies

59
Multiyear term policies may have benefits that
decrease, increase, or remain level

• Decreasing term policy premiums remain the same
• Increasing term policy premiums increase at each
  renewal
• Level term policies pay the same amount of
  benefits
• Renewable term policies renew the policy at the
  end of each term at a higher premium
• Convertable term policies convert the policy to
  a whole life policy (from non-savings to savings)
  at a higher premium
• Reentry term policies insured to pass regular
  medical examinations to qualify for low rates

60
Use of term life insurance

• The need for life insurance is temporary, or
• People need the maximum coverage with limited
  financial resources
• III. Whole Life Insurance
• The policies promise to pay the beneficiary
  whenever death occurs
• Difference from both property insurance and term
  life insurance the insurer must eventually pay a
  claim on every whole life policy

61
Cash ValuePositive difference between
level-premium and mortality cost, plus its
interest.

• Contractual rights of cash value
• Withdraw all cash value if policy owners want to
  end the policy
• Convert it to purchase an annuity
• Borrow all or a proportion of cash value
• Some terminally ill insureds can receive
  accelerated death benefit---a percentage of a
  policys face

62
Types of whole life policies

• Single-premium whole life insurance insureds pay
  a large premium once and all
• Continuous-premium whole life insurance insureds
  pay a level-premium until his death
• Limited-payment whole life insurance insureds
  pay a level-premium for a limited number of years
• Modified whole life insurance level-premium
  rising in stair steps
• Combination whole life insurance decrease term
  policy combines with additions to the whole life
  policy premium

63
The Use of Whole Life Insurance

• Whole life insurance policies meet peoples needs
  for permanent protection combined with savings
• Reasons for saving with life insurance
• Example of a whole life ledger sheet
• IV. Buy Term and Invest the Difference
• There is difference between a term insurance
  premium and a whole life insurance premium.
  People can buy term policy and invest the
  difference to other products.

64
V. Universal Life Insurance

• People buy a term policy and invest an additional
  amount with the insurance company.
• The minimum premium is to keep a term insurance
  in force.
• The insured is allowed to determine the amount
  and frequency of the premium payments within
  limits.
• A guaranteed rate is specified in the contract,
  while an excess interest rate is determined by a
  formula or by company declaration.

65
Universal Life Insurance Death Benefits

• Plan A A death benefit remains unchanged at
  first, then, after the cash value passes a
  threshold, the cash value is added to the death
  benefit.
• Plan B A death benefit increases with the growth
  of the cash value.
• Advantages of Universal Life Insurance
• Flexibility of Premium Payments
• Ability to earn a great return when interest
  rates rise
• Flexibility of death benefits
• Example of a Ledger Sheet for Universal Life
  Insurance

66
V. Variable Life Insurance

• A modification of universal life insurance
• One insured has two accounts an insurance
  account and a separate account
• VI. Annuities

67
14. Medical Expense and Disability Insurance

• Increasing Heath Care Costs
• From 19701995 average U.S. consumption prices
  increased 3.93 times (annual rate of 5.4) while
  medical care price increased 6.49 times (annual
  rate of 7.5)
• In the developed countries, some European
  countries has not enforced the commercial
  medicare plans.

68
II. Common Contract Provisions

• Entire contract
• Grace period
• Reinstatement
• Incontestable clause
• Claims
• Physical exam and autopsy
• Legal action
• Change of beneficiary
• Optional contract provisions
• Definitions and exclusions

69
III. Five Kinds of Health Insurance Coverage

• Basic medical expense insurance
• Covers the costs of both hospitalization and
  outpatient
• Blue Cross and Blue Shield insurance policies pay
  benefit directly to the service provider
• Insurance companies other than Blue Cross
  typically provide reasonable and customary
  payments
• First dollar coverage basic medical insurance
  policies often have no-deductible provision
• Surgical contracts
• Specify a maximum amount of coverage. If one
  patient needs more than one procedures, the most
  expensive treatment determines the payment.

70
B. Major Medical Insurance

• Major medical policies have a substantial
  deductible provision
• Major medical policies have a participation
  provision
• Major medical policies have a high limit of
  liability
• C. Disability Income Insurance
• Replaces income not earned because of illness or
  accident.
• Short-term 30 weeks with an elimination period
  of 1 week.
• Long-term from the date of disability to
  retirement with an elimination period of 6
  months.
• It is a logical complement to life insurance.

71
D. Medicare Supplement Insurance

• Is to supplement benefits provided under the
  Medicare program.
• IV. Long-Term Care Insurance
• V. Health Insurance Providers
• Life insurance companies, Blue Cross, Blue
  Shield,
• In recent years,
• HMOs health maintenance organizations
• PPOs preferred provider organizations

72
(No Transcript)
73
(No Transcript)
74
(No Transcript)