FINC 300: Exam #2

What is the risk management process?

1. Identifying and analyzing loss exposures

2. Examining the feasibility of alternative techniques available for treating those exposures

3. Selecting the most appropriate combination of those techniques

4. Implementing the selected techniques

5. Monitoring results and considering the need for change or improvement

What step in the risk management process is this situation: You are the CFO in Urban University and in charge of the commercial insurance purchased for the university. One day, the principle of the university decides to open the university’s gym to children who lived in the neighborhood for their use after school. What is your response? Will this decision bring more risks to the university?

Step five: Monitoring and improving your risk management program

What is the relationship between insurance and risk management?

• Insurance is a risk financing technique

• Risk management is broader is the sense that it includes five steps

• Risk financing is one component in the second step in the risk management process

What is the rule of thumb used by many risk managers?

Each exposure be treated with at least one risk control technique and at least one risk financing technique

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 with the risk

What are the basic characteristics of insurance?

• Pooling

• Payment of fortuitous losses

• Risk transfer

• Indemnification

Pooling

Spreading losses incurred by the few over the entire group

Fortuitous Loss

A loss that is unforeseen, unexpected, and occur as a result of chance

Risk Transfer

A pure risk is transferred from the insured to the insurer, who typically is in a stronger fianncial position

Indemnification

The insured is restored to his or her approximate financial position prior to the occurrence of the loss

What are the characteristics of an ideally insurable risk?

• Large number of exposure units

• Accidental and unintentional loss

• Determinable and measurable loss

• No catastrophic loss

• Calculable chance of loss

• Economically feasible premium

Why is a large number of exposure units a characteristic of an ideally insurable risk?

To predict average loss based on the law of large numbers

Why is accidental and unintentional loss a characteristic of an ideally insurable risk?

To assure random occurrence of events

Why is determinable and measurable loss a characteristic of an ideally insurable risk?

To determine how much should be paid

Why is no catastrophic loss a characteristic of an ideally insurable risk?

To allow the pooling technique to work

Why is a calculable chance of loss a characteristic of an ideally insurable risk?

To establish a premium that is sufficient to pay all claims and expenses and yields a profit during the policy period

Why is an economically feasible premium a characteristic of an ideally insurable risk?

So people can afford to purchase the policy

What kind of risks can be insured?

Personal, property, and liability

What types of risks are difficult to insure

Market, financial, production, and political

Exposures to catastrophic loss can be managed by using ______

Reinsurance

Reinsurance

Dispersing coverage over a large geographic area, or using financial instruments, such as catastrophe bonds

What is necessary for insurance to be an attractive purchase?

The premiums paid must be substantially less than the face value, or amount, of the policy

Adverse Selection

The tendency of persons with a higher-than-average chance o floss to seek insurance at standard rates

What happens if adverse selection is not controlled by underwriting?

Higher-than-expected loss levels

What can adverse selection be controlled by?

• Careful underwriting

• Policy provisions

Underwriting

Selection and classification of applicants for insurance

What is an example of an insurance policy provision?

Suicide clause in life insurance

How is insurance and gambling different?

• Insurance handles an already existing pure risk, is always socially productive, and both parties have a common interest in the prevention of loss

• Gambling creates a new speculative risk, is not socially productive, and the winner’s gain comes at the expense of the loser

Private Insurance

Includes life and health insurance as well as property and liability insurance

Government Insurance

Social insurance programs and other government insurance plans

Life Insurance

Pays death benefits to beneficiaries when the insured dies

Health Insurance

Covers medical expenses because of sickness or injury

Property Insurance

Indemnifies property owners against the loss or damage of real or personal property

Liability Insurance

Covers the insured’s legal liability arising out of property damage or bodily injury to others

Casualty Insurance

Refers to insurance that covers what is not covered by fire, marine, and life insurance

What are the two categories that private insurance can be grouped into?

Personal lines and commerical lines

Personal Lines

Coverages that insure the real estate and personal property of individuals and families to provide protection against legal liability

Commercial Lines

Coverages for business firms, non-profit organizations, and government agencies

Social Insurance Programs

• Financed entirely or in large part by contributions from employers and/or employees

• Benefits are heavily weighted in favor of low-income groups

• Eligibility and benefits are prescribed by statute

What are some examples of social insurance programs?

Social security, unemployment, and workers comp.

Other Government Insurance Programs

Found at both the federal and state level

What are some examples of other government insurance programs?

Federal flood insurance and state health insurance pools

Exercise: There are numerous definitions of insurance. Based on the definition stated in the texts below, indicate whether each of the following guarantees is considered insurance.

• The manufacturer guarantees a new television against defects for 90 days

• The manufacturer guarantees a new set of radial tires against road defects for 50,000 miles

• A builder of new homes gives a 10-year guarantee against structural defects in the home

• A cosigner of a note agrees to pay the loan balance if the original debtor defaults on the payments

• A large group of homeowners agrees to pay for losses to homes that are damaged or destroyed by fire during the year

In 2024, U.S. Insurance industry net premiums written totaled ______

$1.7 trillion

The U.S. Insurance industry employed _______ people in 2024

3 million

In the USA, there are around ____ life and health insurers and more than _____ property and casualty insurers

800; 2,500

P/C insurance consists primarily of what kinds of insurance?

Auto, homeowners, and commercial

What kind of insurers accounted for the majority of the premiums written in 2024? What kind of insurers accounted for the rest?

Property and casualty (53.1%); Life/annuity (46.9%)

Who are the top ten writers of life and health insurance by direct premiums written in 2016?

• MetLife Inc.

• Prudential Financial Inc.

• New York Life Insurance Group

• Principal Financial Group Inc.

• Mass Mutual Life Insurance Co., Inc.

• Americal International Group

• Jackson National Life Group

• AXA

• AEGON

• Lincoln National Corp.

Who are the top ten writers of P/C insurance by direct premiums written in 2016?

• State Farm Mutual Automobile Insurance

• Berkshire Hathaway Inc.

• Liberty Mutual

• Allstate Corp.

• Progressive Corp.

• Travelers Companies Inc.

• Chubb Ltd.

• Nationwide Mutual Group

• Farmers Insurance Group of Companies

• USAA Insurance Group

Stock Insurer

A corporation owned by stockholders

What is the objective of a stock insurer?

Earn profit for stockholders by increasing the value of stock and paying dividends

What are the characteristics of stockholders with stock insurers?

• Elect board of directors

• Bear all losses

A stock insurer (can/cannot) issue an assessable policy

Cannot

Mutual Insurer

A corporation owned by the policy owners

What are some examples of a stock insurer?

Allstate, AIG

What do policyholders receive with a mutual insurer?

Dividends or rate reductions

With a mutual insurer, policy owners ____ board of directors who have effective management?

Elect

What are some examples of a mutual insurer?

State Farm, Nationwide

Is Lloyd’s an insurer?

No

Lloyd’s

The world’s leading insurance market that provides services and physical facilities for its members to write specialized lines of insurance

What was Lloyd’s formerly known as?

Lloyd’s of London

What are the important characteristics of Lloyd’s?

• Members join together to form underwriting syndicates

• New individual members now have limited legal liability

• Corporations with limited legal liability and limited liability partnerships can also join Lloyd’s of London

• Members must meet stringent financial requirements

• Lloyd’s is licensed only in a small number of jurisdictions of in the U.S.

Reciprocal Exchange

An unincorporated organization in which insurance is exchanged among the members (called subscribers)

What happens for members of a reciprocal exchange?

• Insurance is exchanged among members

• Each member of the reciprocal insures the other members

What is a reciprocal exchange managed by?

Attorney-in-fact

What is an example of a reciprocal exchange?

Erie Insurance

Most reciprocals are relatively ____ and specialize in a ____ number of lines of insurance

Small; limited

Example: Commercial Insurances Inc. is a large stock property and liability insurer that specializes in the writing of commercial lines of insurance. The board of directors has appointed a committee to determine the feasibility of forming a new subsidiary insurer that would sell only personal lines of insurance, primarily homeowners and auto insurance. The new insurance company would have to meet certain management objectives. One member of the board of directors believes the new insurer should be legally organized as a mutual insurer rather than as a stock insurer. Assume you are an insurance consultant who is asked to serve on the committee. To what extent, if any, would each of the following objectives of the board of directors be met by formation of a mutual property and casualty insurer? Treat each objective separately.

• Commercial insurance must legally own the new insurer

• The new insurer should be able to sell common stock periodically in order to raise capital and expand into new markets

• The policies sold should pay dividends to the policyholders

• The new insurer should be licensed to do business in all states

Producers

Intermediaries who are licensed as agents and/or brokers and who sell most insurance policies today

Sometimes producers are called ____ agents or brokers

Retail

Wholesalers

Do not deal with the end consumer of insurance

Who is considered a wholesaler?

MGAs and Surplus Lines Brokers

Agent

Legally represents the insurance companies

What does a property and casualty agent have the power to do to the insurer that a life insurance agent normally does not?

Bind the insurer

Binder

Provides temporary insurance until the policy is actually written

What must occur before life insurance becomes effective for the applicant for life insurance?

Applicant must be approved

Broker

Someone who legally represents the insured and solicits applications and attempts to place coverage with an appropriate insurer

Surplus Lines Broker

Licensed to place business with a non-admitted insurer

Surplus Lines

Any type of insurance for which there is no available market within the state, and coverage must be placed with a non-admitted insurer

Managing General Agent (MGA)

A specialized type of “wholesale” producer that, unlike “retail” producers, is vested with underwriting authority from an insurer

Why does MGAs benefit insurers?

They possess expertise that is not al

MGAs are involved with ____ lines of coverage

The functions of MGAs and surplus lines have become _______

Intertwined