FBLA Insurance & Risk Management

Textbook used: https://perpustakaan.poltekkes-malang.ac.id/assets/file/ebook/George_Rejda,_Michael_McNamara_-_Principles_of_Risk_Management_and_Insurance,_Global_Editon-Pearson_(2021).pdf

Risk

No single definition, commonly used is: situations where the probability of possible out-comes can be estimated with some accuracy.

Uncertainty

Situations where possibilities cannot be estimated.

Loss exposure

Any situation where a loss is possible, regardless of whether a loss actually occurs or not.

Objective/degree of risk

The relative variation of actual loss from expected loss. Varies with the square root of # of cases under observation.

Example of objective/degree of risk

10,000 house are insured, on average, 1% or 100 hours burn. Sometimes it may be 90 or 110. There’s a variation of 10 from 100 or 10% relative variation. Variation of actual loss from expected loss.

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 historical averages.

Subjective risk

Uncertainty based on a person’s mental condition or state of mind; varies depending on different perceptions of risk, affecting behavior.

Example of subjective risk

A drunk driver attempts to drive home, they are unsure if they will get home safely or get stopped by the police.

Chance of Loss

Probability that an event will occur; objective and subjective probability.

Objective probability

Uses historical data and statistical analysis to predict the likelihood of losses.

Subjective probability

Individual’s personal estimate of the chance of loss; can be affected by: intelligence, education, use of drugs, etc.

Peril

The cause of loss

Hazard

A condition that creates or increases the frequency or severity of loss. Four types: Physical, moral, attitude/morale, and legal hazards.

What are the four types of hazards?

Physical, moral, attitudinal/morale, and legal hazard.

Physical hazard

Physical condition that increases the frequency or severity of loss; EX: icy roads, defective locks

Moral hazard

Dishonesty or character defects in an individual that increase the severity or frequency of loss; EX: stealing

Attitudinal/morale hazard

Carelessness or indifference to a loss, which increases the severity or frequency of loss; EX: leaving doors unlocked

Legal hazard

Characteristics of the legal system that increases the severity or frequency of loss; EX: statues that require insurers to cover certain benefits

Speculative risk

Situation in which either profit or loss is possible; EX: stocks

Diversifiable/particular risks

Risk that only affects individuals or small groups; can be eliminated with diversification

Nondivesifiable/fundametal risks

Risk that affects the entire company or large # of people or groups; cannot be eliminated for diversification

Enterprise risk

Term that encompasses all major risks faced by a business firm; includes: pure, speculative, strategic, operation, and financial risk.

Strategic risk

Uncertainty regarding the firm’s finical goals and objectives; EX: when a firm enters a new line of business, it may be unprofitable.

Operational risk

Risks from the firm’s business operations; EX: a bank offering online banking services may incur losses if hackers break into the banks’s computers.

Financial risk

The uncertainty of loss because of adverse changes in commodity prices, interest rates, foreign exchange rates, and the value of money.

Systemic risk

Risk of collapse of an entire system or market du to the failure of a single entry or group of entities that can result in the breakdown f the inter financial system.

Personal risks

Risks that directly affect an individual or family; includes: dependents to support, retirement risks, poor health, unemployment, etc.

Premature death

Death of a family member with unfulfilled financial obligations

Property risks

Risk of having property damaged or destroyed from numerous causes; associated with direct and indirect/consequential loss.

Direct loss

Financial loss that results from the physical damage of property.

Indirect/consequential loss

Financial loss that results indirectly form the occurrence of a direct loss; EX: if your house burns down, you may need to rent a hotel, resulting in additional expenses

Types of Pure risk

• Personal risks

• Property risks

• Liability risks

Liability risks

Risks of being sued or held liable for certain events that may occur if you do something that causes bodily or property damage to someone else.

Lein

Legal claim on someone’s property or income to secure payment of debts.

Commercial risk

The potential for a business to suffer financial losses due to various factors including: customer’s ability too pay, a trading partner’s failure to meet obligations, operational issues, and legal liabilities.

Techniques for managing risk

Can be classified as risk control or risk financing.

Risk control

Techniques that reduce the severity or frequency of loss; major techniques include: avoidance, loss prevention, and loss reduction

Avoidance

Avoiding a risk; EX: you can avoid divorce by not marrying

Loss prevention

Technique used to reduce the frequency or severity of loss; EX: by installing a sprinkler system, a fire can be property distinguished, minimizing severity of loss.

What are the types of loss reduction?

• Duplication

• Seperation

• Diversification

Duplication

Having back-ups and copies.

Seperation

Assets are separated to minimize severity of loss from one single event.

Diversification

Reduces the chance of loss by spreading the loss across different parties.

Risk financing

Refers to techniques that provide for the funding of losses; major techniques include: retention, non insurance transfers, and insurance.

Retention

Means that an individual or business retains part or all of the losses that can result from a given risk; passive or active.

Passive retention

Means that certain risk may be unknowingly retained because of ignorance, indifference, or failure to identify risk.

Active retention

Means that individuals are consciously aware of risks and deliberately plans to retain all or part of it.

Self insurance

Part of retention by which part or all of a given loss exposure is retained by the firm.

Speculator

Market participant who seeks to profit from short term price movements

Future contracts

Agreements to buy or sell an asset at a set price on a specific date in the future

Noninsurance transfers

Risk is transferred to a party other than an insurance company either by contracts or hedging.

Hedging

A technique for transferring the risk of unfavorable price fluctuations to a speculator by purchasing and selling future contracts.

Insurance

No single definition, commonly used is: the pooling of fortuitous loses by transfer of such risks to insurers who agree to indemnify insured for such losses.

American Risk and Insurance Association (ARIA)

Premier professional association of risk management and insurance educators and professionals.

What are the basic characters of insurance?

• Pooling of loss

• Payment of fortuitous losses

• Risk transfer

• Indemnification

Pooling of losses

Heart of insurance, pooling is the spreading of losses insured by the few over the entire group.

Payment of fortuitous losses

A loss that is unforeseen an unexpected by the insured and occurs as a result of chance.

Risk transfer

Pure risks being transferred form the insured to the insurer.

Indemnification

Insured is restored to their approximate financial position prior to the occurrence of loss.

Characteristics of insurable risk

• Large # of exposure units

• Accidental/unintentional loss

• Determinable and measurable loss

• No catastrophic loss

• Culpable chance of loss

• Economically feasible premium

Large # of exposure units

Large number of similar exposure units subject to the same perils; for pooling.

Accidential/unintentional loss

One will not be indemnified if loss is deliberate

Determinable and measurable loss

Loss should be definite to cause, time, amount, and place.

No catastrophic loss

A large number of exposure units should not incur losses at the same time because then pooling wouldn’t work; combatted by reinsurance

Reinsurance

Insurer transfers to another insurer (reinsurer) part or all of of the potential losses.

Culculable chance of loss

Insurer must be able to calculate both the average frequency and severity of the future losses with someone accuracy; this is so proper premiums can be charged.

Economically feasible premium

Means that insured must be able to afford the premium.

Adverse selection

The tendency of someone with a higher than average chance of loss to seek insurance at a standard (average) rates, which if not controlled by underwriting and policy provisions, results in loss and unprofitable business.

Underwriting

Process of selecting and classifying applicants for insurance.

Policy revision

The specific terms and conditions outlined in an insurance policy that define right and responsibilities of both parties.

Hazard risks

Risk associated with organizations property, liability, and personnel-related loss exposures; what traditional risk management was limited to

Governance/compliance risk

Organizations are answerable to various regulatory agencies and to their owners and must meet numerous legal and governmental requirements

Risk register

A listing of the risks faced by an organization with pertinent information about each risk.

Risk map

A grid on which risks facing the organization are charted based on potential frequency and severity of loss; severity Y axis frequency X axis

Risk appetite

The total exposure than organization is willing to accept, given the risk and return trade0ff for an individual risk or in aggregate fr the portfolio of risks.

Risk tolerance

The amount of uncertainty that an organization is willing to accept.

Cost of risk

Total costs associated with treating the organization’s loss exposures;

cost of risk = retained losses + insurance premiums + loss control

Reasons for reinsurance

• Increase underwriting capacity

• Stabilize profits

• Reduce the unearned premium reserve

• Provide protection against a catastrophic loss

The two types of reinsurance

Facultative reinsurance and treat reinsurance

Facultative reinsurance

An optional, case-by-case, method that is used when the ceding company receives an application for insurance that exceeds its retention limit.

Treaty insurance

An agreement under which the primary insurer must automatically cede to the reinsurers all business written in a certain category, and the reinsurer must accept the business.

Environmental Protection Agency (EPA)

Requires facilities with hazardous chemicals to create risk management plan for accident prevention.

Occupational Safety and Health Administration (OSHA)

Sets safety standards in workplace.

National Fire Protection Association (NFPA)

Provides standards and guidelines for insurance and risk management by defining best practice to prevent fire, electrical and other hazards..

Employee Retirement Income Security Act of 1974 (ERISA)

Sets minimum standards for health and retirement plans.

Consolidated Omnibus Budget Reconciliation Act of 1985 (COBRA)

Allows for family to keep employer’s group health insurance temporarily after losing your job, or other life events like divorce or death of an employee by paying premium yourself.

Basic insurance policy features

• Premium

• Deductible

• Coverage limits

• Exclusions

• Endorsements (added coverage)

• Policy period.

Risk aversion

Tendency to prefer certainty over uncertainty; people would rather accept a smaller, guaranteed payoff than risk a potentially larger but uncertain one.

Term insurance

A type of life insurance that provides a death benefit if you die within a specified period of time; no cash value, lower cost.

Permanent insurance

Type of life insurance that provides lifelong coverage; includes cash value, higher premiums;

Insurance portfolio

Collection of policies covering different risks

Principle of Indemnity

States that the insurer agrees o pay no more than the actual amount of the loss; insured should not profit from loss.

Principle of Insurable Interest

States that the insured must be in a position to lose financially if a covered loss occurs.

Principle of Subrogation

Means that substitution of the insurer in place of the insured for the purpose of claiming indemnity from a third party for a loss covered by insurance; the insurance company is entitled to recover from a negligent third party any loss payments made to the insured.

Principle of Utmost Good Faith

A higher degree of honesty is imposed on both parties to other contracts.

Warranty

A statement that becomes part of the insurance contract and is guaranteed by the maker to e in true in all respects.

Commutative contract

Contract in which the values exchanged by both parties are theoretically equal.

Aleatory contract

Contract where the values exchanged may not be equal but depend on an uncertain event.

Unilateral contract

Contract by which only one party makes a legally enforceable promise

Conditional contract

The insurer’s obligation to pay a climate depends on whether the insured has compiled with all policy conditions