insurance and risk final

risk

uncertainty about chance, timing, or amount of loss (if vs. when).

chance of loss

the probability that an event will occur. 

objective risk

the relative variation of actual loss from expected loss. 

law of large numbers

implies objective risk varies inversely with the square root of the number of cases.

subjective risk

uncertainty based on a person's mental condition or state of mind.

peril

the cause of loss (fire, wind, water, theft)

hazard

a condition that increases the frequency or severity of a loss.

physical hazard

eg: icy road

moral hazard

A more active choice that a person makes. eg: setting house on fire

morale hazard

You would be indifferent to a loss. 

pure risk

chance of loss or no loss. No chance of gain

speculative risk

chance of loss, no loss, or gain (investing)

particular risk

the risk that affects individuals only as individuals.

fundamental or systemic risk

risk that affects a large number of individuals or the entire economy.

enterprise risk

a term that encompasses all major risks faced by a firm. Business focused. (operational, financial, strategic, reputational)

types of property risk

direct and indirect

direct loss

financial loss that results from the physical damage, destruction, or theft of property. (phone breaks when dropped)

indirect loss

financial loss arising from loss of use of property. (lost business or lost future opportunity.) not a physical loss.

liability risks

responsibility for actions that cause injury or property damage to another with no max upper limit

outlays to reduce risk

ways to decrease risk.

opprotunity cost

Making decisions that potentially decrease the chance of gain.

expenses from financing potential losses

protecting yourself prior to something bad happening to you. Spending money to save it.

cost of losses not reimbursed

money lost and not reimbursed

Fortuitous loss

random losses that are accidental. Intentional ones are not paid.

Indemnification

“to make whole”. The insured is restored to the condition prior to the loss

Pooling of Losses

spreading losses of a few over an entire group (pool)

Payment of fortuitous losses

pay for losses that are unexpected or occur as a result of chance

Risk transfer

pure risk transfer from the insured to the insurer

diminishing pooling effect

The economic principle states that as one input unit is increased, there is a point at which the marginal increase in output begins to decrease.

Fortuitous Loss

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

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.

Underwriting

risk classification, basically discriminating based on risk. involves selecting and classifying insurance applicants. Has certain standards that must be met for preferred/ standard rates

Policy Provisions

rules that try to stop clients from trying to get insurance money

• Ex: suicide clause in life insurance

types of private insurers

life and health, property and casualty

life and health insurance

these insurers sell life and health insurance products, annuities, mutual funds, pension plans, and related financial products.

property and casualty insurance

sell property and casualty insurance and related lines, including marine coverages and surety and fidelity bonds

Insurers can also be classified by their organizational form

• Stock insurers

• Mutual insurers

• Reciprocal exchanges

• Llyod’s of London

Stock Insurer

A corporation owned by stockholders. Their objective is to earn a profit for stockholders. Stockholders elect a board of directors who in turn appoint executive officers to manage the corporation

Mutual Insurer

a corporation owned by the policy owners. Policyowners elect a board of directors, who have effective management control. May pay dividends to policyowners, or give a rate reduction in advance

Lloyd’s of London

are not insurers, but a society of members who underwrite insurance in syndicates. Membership includes corporations, individual members (names), and Scottish limited partnerships. Members must meet stringent financial requirements

Insurance Agent

someone who legally represents the insurer.

Property and Casualty Agent

has power to bind the insurer

Life Insurance Agent

normally does not have the authority to bind the insurer

• Applicant for life insurance must be approved by the insurer before the insurance becomes effective

Insurance Broker

someone who legally represents the insured AND

• Solicits application and attempts to place coverage with an appropriate insurer.

Large Brokerage firms have knowledge of

• Highly specialized insurance markets

• Risk management and loss-control services

• The needs of large corporate insurance buyers. 

• Know markets better and are helpful to bigger than just one individual looking for an independent policy.

Loss exposure

any item exposed to loss; any situation in which a loss may occur.

risk management process

1. identify potential losses

2. Evaluate potential losses

3. Select the appropriate risk management techniques

4. Implement and monitor the risk management program (most commonly fails)

Risk control

reduce frequency or severity of losses

Risk financing

techniques that provide for the funding of losses

Retention

firm retains part or all the losses that can result from a given loss (most effective when there is no other option)

Loss prevention

reducing frequency of loss (no open flames to prevent fire)

• Loss reduction

aims to lower severity of loss (fire extinguishers)

Captive

A captive insurer is an insurer owned by a parent form for the purpose of insuring the parents firm loss exposure

financial risk management

refers to the identification, and treatment of SPECULATIVE financial risks

enterprise risk management

comprehensive risk management program that addresses the organizations pure, speculative, strategic, and operational risks.

failures of ERM

• Failure to embrace appropriate behaviors

• Failure to develop and reward internal risk management competencies

• To much reliance on past events as predictors of the future without considering unprecedented events

insurance market dynamics

decisions about whether to retain risks or transfer them are influence by conditions in the insurance marketplace.

The Underwriting Cycle

refers to the cyclical pattern of underwiting stringency, premium levels, and profitability

Hard Market

tight underwriting standards, high premiums, unfavorable insurance terms to lead to more retention

Soft Market

loose underwriting standards, low premiums, favorable insurance terms to lead to more retention

Combined Ratio

(losses + loss adjustment expenses + underwriting expenses)/ premiums

Insurance Industry Capacity

• Many factors influence property and casualty insurance pricing and underwriting 

• Required to have cash on hand

Consolidation

taking many things and turning them into a few bigger things (doing this with insurance)

what is one of the benefits of health insurers merging?

to diversify their goods and services

how can we create insurable risk?

securitization

why are CAT bonds good for the insured

allow people to not pay at all or pay later if a catastrophic event occurs.

Probability analysis

examining probabilities and figuring out whether losses are related or not.

Regression analysis

characterizes relation between two or more variables and is used to predict values of a variable. How much something affects a loss.

Loss distributions

probability distribution of losses that could occur.

ways to increase capital as a firm

debt and equity. firms want to offer debt(bonds) because firms do not want to give up their ownership

how to find expected loss for individuals

probability(loss)+ probability(loss)

how to find standard deviations for individuals

(probability(loss-expected loss)² + (probability(loss-expected loss)² ALL MULTIPLIED BY 1/2

risk management matrix

1. identify potential losses

what kind of losses does the firm face?

2. evaluate potential losses

loss severity and frequency

3. select the appropriate risk management techniques

risk control/ financing, loss prevention/reduction, and retention

4. Implement and monitor the risk management program

A: outlines firms risk management objectives

B: outlines firms policy to treat risk exposure

C: educates top level executives in regards to risk management process.

why captives are formed

• Parent may have difficulty obtaining insurance

• Favorable regularity/ tax environment

• Costs may be lower than purchasing commercial insurance

advantages of retention

• Save on loss costs (long run)

• Increase cash flow

• Encourage loss prevention

disadvantages of retention

• Possible higher losses (short run)

• Possible higher expenses

• Possible higher taxes

credit default swaps

Agreement in which the risk of a default of a financial instrument (such as a bond) goes from the owner of the instrument to the issuer of the swap. You keep the bond but if it defaults, the CDS will pay you whatever you lost and whatever you are owed.

catastrophe bonds

• Insurable risk is transferred to capital markets through the creation of financial instruments. 

• Need invested funds to be held by an impartial third party. 

• Helps increase capital

what can a catastrophe bond do that a regular one cannot?

payments can be differed or not paid at all

why do health insurance companies merge?

• They merge for diversification (of risk) and negotiations. 

• The larger the merger and the companies, the smaller the market gets. Just going to be a few big companies.  

over the last 10-15 years, when compnaies merge, they are usually met with angry clients

Principle of Indemnity

insurer agrees to pay no more than the actual amount of the loss. Approximate indemnification through an insurance company. The point is that the client breaks even from loss, no profit. Also reduces moral hazard. 

Actual cash value

figuring out how much $ the client gets after loss

replacement cost insurance

replacement cost - depreciation

fair market value

price a willing buyer would pay the seller

broad evidence rule

overview from depreciation, replacement cost, PV, appraisals, etc.

exceptions to the principle of indemnity

• valued policy- set value paid upon loss

• replacement cost insurance- not worrying about depreciation

• life insurance- type of valued policy

Principle of Insurable Interest

the insured must be in a position to lose financially if a loss occurs. Client care about whatever it is they are insuring.

The purpose of the principle of insurable interest

Prevent gambling, help measure the amount of loss in property insurance, reduce moral hazard

when insurance interest is required

• Property insurance: contract of indemnity. At the time of loss. Might not have insurable interest at the time of purchase of insurance. 

• Life insurance: not a contract of indemnity. Only at time of purchase. Not necessary at the time of death.

Principle of Subrogation

insurer takes the place of the insured in seeking indemnity from another person. Insurance acts for you after a loss in terms of lawsuit or something else. Both parties may have different goals though which may cause issues. 

when and how does the principle of subrogation happen

• After payment of loss to insured

• Insurer attempts to recover payment from the responsible party.

Principle of Utmost Good Faith

higher degree of honestly placed on both parties after a contract is imposed.

justification for principle of utmost good faith

there is a lot of asymmetry in information

Elements of Utmost Faith

• Statements made by applicant for insurance 

• “Material misrepresentations” on that would have caused the insurer to deny application or issue on different terms. 

• Concealment: if they don’t ask you, you don’t tell. Could stop insurance companies from writing a contract. 

• Warranty: promising to fix whatever is wrong.

Requirements of an Insurance Contract

1. Offer and Acceptance: general- applicant makes offer, insurer accepts. Binder- temporary contract

2. Consideration: insurer vs insured 

3. Competent parties: not inebriated or disabled

4. Legal purposes

basic parts of insurance contract

• declaration

• definition

• insuring agreement

• exclusions and agreements

• miscellaneous provisions