Risk Management and Insurance study guide

What is risk?

Uncertainty concerning the occurrence of a loss.

What is pure risk?

A situation where there are only two possible outcomes: loss or no loss (no gain)

What is speculative risk?

A situation where there are three possible outcomes: loss, no loss/no gain, or gain.

is this a pure risk or speculative: buying a lottery ticket

speculative

Is this a pure risk or speculative: your car being stolen

pure

what is a peril?

The cause of a loss. It’s the event that directly leads to the loss (fire, theft, earthquake, collision, windstorm, flood, illness, death)

what is hazard?

A condition that increases the chance of loss from a particular peril, or increases the severity of the loss. Hazards dont cause the loss themselves, but make it more likely or worse.

Physical Hazard

physical condition that increases the chance or severity of loss (icy roads)

moral hazard

dishonesty or character defects in an individual that increase the chance of loss. Arises from the fact that a person with insurance may exaggerate a loss to collect benefits

moral (attitudinal) hazard

Carelessness or indifference to a loss because of the existence of insurance. Its a subconscious or conscious change in behavior due to insurance.

what is risk management

Systemic process for identifying, assessing, and controlling threats to an organizations capital and earnings. Its about minimizing the adverse effects of risk.

Risk management process Step 1: Identify Loss Exposures

Determine what assets, liabilities, and personnel are exposed to potential loss. (surveys, fin state., hist. data)

Risk management process Step 2: Analyze Loss Exposures

Evaluate the frequency (how often) and severity (how bad) of potential losses.

Risk management process Step 3: Select appropriate Techniques

Choose strategies to handle identified risks (risk control and risk financing)

Risk management process Step 4: Implement and monitor risk management

Put the strategies into action and regularly review their effectiveness, making adjustments as needed.

Maximum Possible Loss

The worst loss that could possibly happen to the organization from a single event. It represents the maximum financial impact under the most extreme, but conceivable, circumstances.

Probable maximum loss

The worst loss that is likely to happen to the organization from a single event. It’s a more realistic estimate, considering normal operating conditions and existing loss control measures.

Coefficient of variation (COV = Mean (expected value))

A relative measure of risk. It expresses the standard deviation as a percentage of the mean. high COV = greater relative variability (risk). low COV = less relative variability (risk)

Risk control (minimizing losses)

Techniques that reduce the frequency or severity of losses.

Avoidance

Eliminating the exposure to loss entirely. (pro = eliminates risk; cons = may miss out on potential profits/opportunities)

Loss prevention

Reducing the frequency of a particular loss

Loss reduction

Reducing the severity of a particular loss after it occurs (exit signs, rehab)

Duplication

Having backup copies of important documents or property (storing data off site)

Separation

Spreading assets or operations geographically to prevent a single event from causing a total loss (owning multiple warehouses)

Diversification

Spreading risk across different investments or products to reduce the impact of any single failure (Investing in various stocks)

Risk Financing (paying for losses)

Techniques for generating funds to pay for losses

Retention (Self insurance)

Retaining part or all of the losses that can occur

planned retention

deliberately deciding to retain a risk (setting self insurance fund)

Unplanned retention

unknowingly retaining a risk because it wasn’t identified

When to retain

high frequency, low severity losses (minor scratches on company car) or if no insurance or too expensive

Non insurance transfers (contractual transfers)

Transferring a risk to another party through a contract (EX: indemnification agreements, lease, warranties)

Insurance

Transferring pure risks to an insurer, who agrees to pay for losses in exchange for a premium. (this is specific type of risk transfer)

low frequency / low severity

Best handled by retention (small losses, minor repairs)

low frequency / high severity

Best handled by transfer (insurance) these are the catastrophic but unlikely events that insurance is designed for

High frequency / low severity

best handled by retention combined with loss prevention (to reduce the frequency; ex: small claims, often self insured or managed with high deductibles)

High frequency / High severity

These are the most problematic. Best handled by avoidance if possible, or aggressive loss reduction if avoidance is not feasible. If neither is possible, the exposure may be uninsurable or require significant risk management effort.

Pooling

The spreading of losses incurred by the few over the entire group, so that average loss is substituted for actual loss. Its the essence of insurance.

impact of pooling: loss distribution

the actual loss experience for the pooled group becomes more predictable and approaches the expected loss. distribution of potential losses for for individual members becomes tighter around the mean

impact of pooling: Mean (expected loss)

Remains the same (the average loss per person in the pool)

impact of pooling: standard deviation

decreases as more units are added to the pool. This is due to the law of large numbers, which states that as the number of exposure units increases, the actual loss experience will approach the expected loss experience.

Impact of pooling: Risk (P/individual)

Decreases. while the total risk for the pool might increase with more people, the risk per individual (variability of actual loss from expected loss) is significantly reduced. this allows fro greater predictability and lower risk premiums.

Ideally insurable risk: Large number of exposure units

there must be a sufficiently large number of similar but independent exposure units so that the law of large numbers can operate. why? allows the insurer to predict future losses with greater accuracy and stability, enabling the calculation of a fair premium

Ideally insurable risk: Accidental and unintentional loss

the loss must be fortuitous, unforeseen, and unexpected from the standpoint of the insured. why? prevents moral hazard (ppl intentionally causing losses to collect insurance) and ensures that losses are not premeditated or certain to occur

Ideally insurable risk: determinable and measurable loss

the loss must be definite as to cause, time, place, and amount. why? allows the insurer to determine if a loss is covered and how much should be paid. without this, claims adjudication would be impossible

ideally insurable risk: No catastrophic loss

Losses should not be so severe that they affect a large proportion of policyholders at the same time, or threaten the solvency of the insurer. why? prevents the insurer from facing financial ruin due to a single event (natural disaster affecting many insured props.). Insurers use diversification, reinsurance, and geographical dispersion to manage this.

Ideally insurable risk: Calculable chance of loss

The insurer must be able to calculate the average frequency and average severity of future losses. why? essential for pricing the premium accurately. without this, the insurer cannot determine a financially sound premium

Ideally insurable risk: Economically feasible premiums

Premium must be affordable to the insured and not so high that people are unwilling to purchase the insurance. Why? if premium is too high relative to the potential loss, no one will buy the insurance, making it impossible for the insurer to operate

Benefits of insurance to society: Indemnification for loss

Provides financial compensation for covered losses, allowing individuals and businesses to recover financially.

Benefits of insurance to society: Reduction of worry and fear

Provides peace of mind, knowing that financial protection is in place

Benefits of insurance to society: Source of investment funds

Insurers collect premiums and invest them, contributing to economic growth and capital formation

Benefits of insurance to society: Loss prevention and reduction

Insurers incentivize risk control through lower premiums, provide risk management advice, and fund research on loss prevention.

Benefits of insurance to society: Enhancement of credit

Lenders often require insurance (homeowners insurance for a mortgage) making more credit more accessible

Costs of insurance to society: Operating expenses

Premiums must cover administrative costs, marketing, claims adjustment, etc.

Costs of insurance to society: Fraudulent claims

Dishonest policyholders submit false claims, leading to higher premiums for everyone

Costs of insurance to society: Inflated claims

Exaggerating the amount of loss, also leading to higher premiums

Costs of insurance to society: Moral hazard & morale hazard

can lead to increased frequency or severity of losses, driving up costs.