RMI Chapters 1-6

Risk

uncertainty concerning the occurrence of a LOSS

Loss Exposure

Any situation or circumstance in which a loss is possible, regardless of whether a loss occurs or not.

Objective Risk

defined as the relative variation of actual loss from expected loss. It can be statistically calculated using a measure of dispersion, such as the standard deviation.

Subjective Risk

uncertainty based on a persons mental condition or state of mind. Two persons in the same situation may have different perceptions of risk. High subjective risk often results in conservative behavior.

Peril

the cause of loss. Example, a car crash, the collision is the ______

Hazard

a condition that increases chance of loss

Physical Hazard

physical conditions that increase chance of loss

Moral Hazard

dishonesty or character defects in an individual that increase the chance of loss. Faking something like a fire or a car accident.

Attitudinal Hazard

(Morale Hazard) carelessness or indifference to a loss which increases the frequency or severity of loss.

Legal Hazard

refers to characteristics of the legal system or regulatory environment that increase the chance of loss. (Large damage awards in liability lawsuits)

Pure Risk

one in which there are only the possibilities of loss or no loss. Example is earthquake

Speculative Risk

one in which both profit or loss are possible. Example is gambling

Diversifiable Risk

affects only individuals or small groups, also known as nonsystematic or particular risk.

Nondiversifiable Risk

affects the entire economy or a large number of people within the economy. aka systematic or fundamental risk

Enterprise Risk

encompasses all major risks faced by a business that include pure, speculative, strategic, operational, and financial risk.

Strategic Risk

risk that arises from decisions made by the board of directors

Operational Risk

risk that is connected to internal resources, systems, processes, and employees.

Financial Risk

risk that refers to the uncertainty of loss because adverse changes in commodity prices, interest rates, foreign exchange rates, and value of the dollar.

Enterprise Risk Management

combines into a single unified treatment program all major risks faced by the firm: pure, strategic, operational, and financial.

Personal Risks

involve the possibility of a loss or reduction in income, extra expenses, or depletion of financial assets. Examples of this can be:

-Premature death of head of family

-insufficient income during retirement

-poor health (medical bills, loss of income)

-involuntary unemployment

Property Risks

involve the possibility of losses associated with the destruction or theft of property. Physical damage to a home from vandalism, fire, tornado, etc.

Direct Loss

a financial loss that results from the physical damage, destruction or theft of property, such as a fire to a home.

Indirect loss

results indirectly from the occurrence of a direct physical damage or theft loss, like additional living expenses after a fire. These expenses would be consequential loss.

Liability Risk

involve the possibility of being held liable for bodily injuries or property damage to someone else. There is no maximum with respect to the amount of loss. A lien can be placed on your income and financial assets. Defense costs can be enormous.

Commercial Risk

firms face a variety of pure risks that can have serious financial consequences if a loss occurs. This could be property risks, liability risks, loss of business, or others like crime, HR exposure, etc.

Burden of Risk

Three Burdens:

1. In absence of insurance, individuals would have to maintain large emergency funds.

2. Risk of liability lawsuits may discourage innovation, depriving society of goods or services

3. Risk causes worry or fear.

Insurance

a social device in which a group of individuals (insured) transfers risk to another party (insurer) in order to combine loss experience, which permits statistical prediction of losses and provides for payment of losses from funds contributed (premiums) by all members who transferred risk.

Insurable Loss (from the point of the insurance company)

For a loss to be insurable, it must be:

-Large number of homogeneous units (in order to predict average loss)

-Accidental and unintentional losses (to control moral hazard)

-Definite in time and place, measurable and of sufficient severity to cause economic hardships (to enable loss adjustment)

-Non-catastrophic (to allow pooling technique to work, not all insurance companies are being hit at once, draining the pool)

Insurable Loss (point of view of the insured)

Does this exposure warrant protection? Is the probability of loss low? How much is the premium for low probability exposures?

Adverse selection

undisclosed information caused people to pay less than their “fair” share

causes subsidization

because included with people paying more than their “fair” share

Private Insurance

Property-liability insurance, Life insurance, Personal lines, Commercial lines

Property-liability insurance

fire, marine (boat), casualty, workers compensation

life insurance

life and health, annuities

Other kinds of insurance

weather insurance, municipal bond, boiler and machine, motion picture compensation

Personal lines

cover real estate, personal property, or provide protection against legal liability

Commercial Lines

coverage for businesses, nonprofit organizations

government insurance

social insurance programs: social security, medicare, unemployment insurance

other: national flood insurance program, state health insurance pools

Costs of Insurance System

fraud and cost of doing business

benefits of Insurance Systems

payment for losses, peace of mind, loss prevention, facilitate credit, financial intermediation

risk management

making a pre-loss arrangement for post-loss resources, managing the risk, the logical way of controlling loss exposure.

Risk management statement of objectives

survival and growth, compliance with government regulations, efficiency, procedures and principles are implemented and followed

Steps of Risk Management Process

1. Identify

2. Measure (evaluate)

3. Choose most efficient tool(s) for loss control and loss of finances

4. Implement and review

Loss frequency

an estimate (numerical or verbal) as to the number of times the loss will occur

Loss severity

refers to the probable size of the loss that may occur; more important than loss frequency

maximum probable loss

a conservative estimate of what is likely to occur in a worst case loss

risk control

techniques that reduce the frequency and severity of loss; methods include avoidance, loss prevention, and loss reduction

avoidance

means a certain loss exposure is never acquired, or an existing loss exposure is abandoned, the chance of loss is reduced to zero, and it is not always possible or practical to avoid all losses

loss prevention

take various steps to reduce the probability of losses occuring

loss reduction

steps designed to reduce severity, take steps to reduce the damage before and after a loss

retention

the firm assumes part or all of the losses

retention level

the dollar amount of losses that the firm will retain,

max retention can be calculated as a percentage of the firms networking capital

methods for paying retained losses:

current net income: losses are treated as current expenses

unfunded reserve: losses are deducted from a bookkeeping account

funded reserve: losses are deducted from a liquid fund

credit line: funds are borrowed to pay losses as they occur

deductible

a provision by which a specified amount is subtracted from the loss payment otherwise payable to the insured

excess insurance policy

is one in which the insurer does not participate in the loss until the actual loss exceeds the amount a firm has decided to retain

manuscript policy

a policy specially tailored for the firm; language in the policy MUST be clear to BOTH parties; the parties must agree on the contract provisions, endorsements, forms and premiums.

hard market

profitability is declining, standards have tightened, premiums increase, and insurance is harder to obtain

soft market

profitability is improving, standards loosen, premiums decline, and insurance is easier to obtain

Stock insurers

incorporated insurance companies owned by investors; investors have limited liability, shares can be traded on an organized exchange (NYSE or NASDAQ)

Examples: Allstate, Lincoln National, Equitable Life, MetLife

Mutual insurers

incorporated, nonprofit organization, owned by policyholders; initial premium followed by dividends

Examples: state farm, liberty mutual

Reciprocal Exchange

unincorporated, nonprofit association (but not a mutual insurance company) third largest auto insurer

Lloyd’s of London

one of a kind coverage, not an insurance company but a coffee shop in 1688,

provided individuals with unlimited liability by being backed by other members of the community

Underwriting

refers to the process of selecting, classifying, and pricing applicants for insurance

Statement of Underwriting Policy

establishes policies that are consistent with the company’s objectives, such as:

acceptable classes of business

amounts of insurance that can be written

Line Underwriter

makes daily decisions concerning the acceptance or rejection of business.

Primary objective of underwriting

to attain an underwriting profit

secondary objective of underwriting

select prospective insured according to the company’s underwriting standards

the purpose of underwriting standards

reduce adverse selection against the insured

adverse selection

is the tendency of people with a higher than average chance of loss to seek insurance at standard rates.

maintain equity

underwriting should also _________ among the policyholders

-the application

-the agents report

-an inspection report

-physical inspection

-physical examination and attending physician report

underwriting starts with the agent in the field, information comes from:

-accept the application

-accept the application subject to restrictions or modifications

-reject the application

after reviewing the information, the underwriter can:

Production

refers to the sales and marketing activities of the insurer

Agent

represents the company, and is often referred to as a producer

Broker

represents the customer/insured

Direct response distribution

mass media advertising, direct mail, internet

ratemaking

refers to the pricing of insurance and the calculation of insurance premiums

a rate is a price per unit of insurance

exposure unit

the unit of measurement used in insurance pricing

actuary

a person who compiles and analyzes statistics and uses them to calculate insurance risks and premiums.

Objective of Insurance Pricing

Find the premium that equals expected costs including a return on capital

4 Determinants of Fair Premiums

-expected claim costs

-administrative costs

-investment income

-profit loading

Pure Premium

the premium that just covers expected claim costs

judgement rating

used when no reliable statistics are available

class rating

Class rating is a method used in insurance to group individuals or properties with similar risk profiles, allowing insurers to assign appropriate rates based on their level of risk

merit rating

class rating adjusted upward or downward according to individual loss experience

Objectives of claims settlement

-verification of a covered loss

-fair and prompt payment of claims

-personal assistance to the insured

claims adjustor

determines if a covered loss has occurred and the amount of loss. proof of loss may be required before the claim is paid. decides if the claim should be paid or denied

reinsurance

an arrangement by which the primary insurer that initially writes the insurance transfers to another insurer part or all of the potential losses associated with such insurance. Used to increase underwriting capacity, stabilizes profits, reduce the unearned premium reserve

ceding company

primary insurer is

reinsurer

the insurer that accepts the insurance from the ceding company is the

retention limit

the amount of insurance retained by the ceding company

cession

the amount of insurance ceded to the reinsurer is known as

unearned premium reserve

represent the unearned portion of gross premiums on all outstanding policies at the time of valuation

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. often used when the primary insurer has an application for a large amount of insurance

Treaty reinsurance

the primary insurer has agreed to cede insurance to the reinsurer and the reinsurer has agreed to accept the business.

securitization of risk

means that an insurable risk is transferred to the capital markets through the creation of financial instruments, such as futures contract

catastrophe bonds

corporate bonds that permit the insurer of the bond to skip or reduce the interest payments if a catastrophic loss occurs. these are growing in importance and are considered to be a standard supplement to traditional reinsurance.

investments

because premiums are paid in advance, they can be invested until needed to pay claims and expenses

investment income

extremely important in reducing the cost of insurance to policyowners and offsetting unfavorable underwriting experience

life insurance contracts

long term, safety of principal is a primary consideration