Risk Management & Analysis Final (Terms/Concepts)

Risk

The probability of the occurrence of a loss that can be estimated with some accuracy

Uncertainty

Such probability cannot be estimated

Assign data

What should one do to transform uncertainty into risk?

Pure Risk

Type of risk that exists when there are only the possibilities of loss or no loss (EQ, car accident)

Speculative Risk

Type of risk that exists when both profit or loss are possible (gambling, stock exchange)

Diversifiable risk (aka nonsystematic or particular risk)

Affects only individuals or small groups

Non-diversifiable risk (aka systematic or fundamental risk)

Affects the entire economy or large numbers of persons or groups within the economy

(government assistance may be necessary to ensure these risks)

Expected Value or Average

A set of n possible outcomes equals the sum of these outcomes, each outcome weighted by the probability of its occurrence

Variance

How we move around the average. Standard deviation squared

Standard deviation

Measures the average deviation from the mean. Indicates the expected magnitude of the error from the expected value as a predictor of the outcome

Random Variable

Variable whose outcome is not known with certainty

Constant Variables

Variables that are not random variables

Discrete Random Variable

Variable that has a specific set of possible values

(ex. total score when two dice are thrown)

Continuous Random Variable

Variable that has a continuing range of possible values

(ex. temperature in a room)

Probability Distribution

Possible outcomes of a random variable and associated probabilities with each possible outcome

Probability of Loss

The probability that an event that causes loss will occur

Objective Probability

Refers to the long-run relative frequency of an event based on assumptions of an infinite number of observations with no change in the underlying conditions (is the same for different individuals)

Subjective Probability

An individual's personal estimate of the chance of loss (between individuals)

Skewness

Measures the degree of symmetry of the distribution

Normal Distribution

A probability distribution that appears as a "bell curve" when graphed. Describes a symmetrical plot of data around its mean value, where the width of the curve is defined by the standard deviation

Central Limit Theorem

States that, under the same assumption as the Law of Large Numbers, the average outcome approaches a normal distribution with mean and standard deviation as n gets very large

Value at Risk (VaR)

The worst probable loss likely to occur at some level of confidence (for a given period, under regular market conditions)

Covariance

A measure of how two random variables are related

Risk Pooling

The spreading of financial risk evenly among a large number of contributors to the program.

*Use in insurance- allows policy holders to replace uncertain payments with a certain payment (premiums)

Cost of risk

Value without risk-value with risk

Beta (β)

Non-diversifiable risk is often measured by

Stakeholders

Individuals and companies who depend on how well a firm is doing but who cannot diversify the impact of the firms risk on their individual situations

Shareholders

The owners of a firm who want the first to be managed in a way that maximizes shareholder welfare

6 Characteristics of an (ideally) insurable risk

1. Large number of exposure units

2. Accidental and unintentional loss

3. Determinable and measurable loss

4. No catastrophic loss / limited loss size

5. Calculable probability of loss

6. Economically feasible

Large number of exposure units

Necessary to predict the average loss based on the law of large numbers

Accident and unintentional loss

The law of large numbers is based on the random occurrence of events

Determinable and measurable loss

Determinable: The loss should be definite as to cause, time, place, and size

Measurable: to determine how much should be paid

No catastrophic loss / limited loss size

This characteristic is important to ensure pooling works as it should. Can be managed by reinsurance, dispersing coverage over a large geographic area, or using financial instruments

Calculable probability of loss

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

Economically Feasible

Ensures people can afford to purchase the policy

Moral Hazard

Occurs when an entity has an incentive to increase its exposure to risk because it does not bear the full costs of that risk

*In insurance: describes insurance-induced behavioral changes of insureds which affect overall outcome)

Adverse Selection

The tendency of individuals with a higher-than-average chance of loss ("bad risks") to seek insurance at standard rates

Ratemaking

The pricing of insurance and the calculations of insurance premiums

Premium=rate*exposure units

Class Rating (Manual Rating)

Exposures with similar characteristics are grouped and charged the same premium

Merit Rating

Class rates are adjusted up or down based on individual loss experience

Judgement Rating

Each exposure is individually evaluated and the rate is determined by the underwriter's judgement

Underwriting

The process of selecting, classifying, and pricing applicants for insurance

Claims

Verify loss is covered by policy, pay claims fairly and promptly, assist the insured after a loss

Loss Ratio

The ratio of incurred losses and loss adjustment expenses to premiums

Combined Ratio

Sum of loss ratio and expense ratio

Methods of Risk Assessment

1. Loss Forecasting

2. Value at Risk Analysis

3. Other RM tools

1. Large number of exposure units

2. Accidental and unintentional loss

3. Determinable and measurable loss

4. No cat loss/ limited loss size

5. Calculable probability of loss

6. Economically feasible premium

What are the 6 characteristics of an (ideally) insurable risk?

Moral Hazard and Adverse Selection

What are the two major insurability problems you should know?

Moral Hazard

Insurance-induced behavioral changes of insureds which affect the overall outcome. Entity has an incentive to increase its exposure to risk because it does not bear the full costs of that risk

Adverse Selection

The tendency of individuals with a higher-than average chance of loss to seek insurance at standard rates

Ratemaking

The pricing of insurance and the calculation of insurance premiums

Premium

Rate * (exposure units)=

Class Rating

Exposures with similar characteristics are grouped and charged the same premium

Merit Rating

Class rates are adjusted up or down based on individuals loss experience

Judgement Rating

Each exposure is individually evaluated and the rate is determined by the underwriter's judgement

Underwriting

Process of selecting, classifying, and pricing applicants for insurance

Claims

Verify loss is covered by the policy, pay claims fairly and promptly, assist the insured after a loss

Loss Ratio

The ratio of incurred losses and loss adjustment expenses to premiums

Loss Ratio Equation

(Incurred losses + loss adjustment expenses) / premiums earned

Underwriting Cycles

The tendency of property and casualty insurance premiums, profits and available coverage to exhibit a cyclical pattern

Soft Market

low prices and generous coverage, low underwriting profits

Hard Market

high premiums, limited coverage, high underwriting profits

Financial pricing hypothesis

Premiums reflect the discounted value of costs associated with losses; temporary deviations from an assumed market equilibrium could be explained by random changes in demand and supply

Capacity constraints hypothesis

The capital market is not perfect in the sense that shocks to capital result in cycles. Capital cannot move immediately and without cost into and out of the insurance market

Financial quality hypothesis

Assumes that an insurance company's premiums endogenously depend on its insolvency potential

Option pricing approach

Assumes policyholders to have a short position in a put option on insurer assets. This put option is referred to as the insolvency put. AN insurer's insolvency risk, and hence the value of the option, increases when insurer capacity goes down.

Combined Ratio

loss ratio + expense ratio =

Overall operating ratio

combined ratio - investment income ratio

Loss Forecasting

Use of different tools and techniques by risk managers to try to predict losses

Risk Management Information System

A computerized database that permits the risk manager to store, update, and analyze risk management data

Risk Management Intranet

A website with search capabilities designed for a limited, internal audience

Risk Map

A grid detailing the potential frequency and severity of risks faced by the organization

Catastrophe modeling

a computer-assisted method of estimating losses that could occur as a result of a catastrophic event

Reinsurance

An arrangement by which an insurer transfers to another insurer part or all of its potential losses

The ceding company

In terms of reinsurance, the primary insurer is called ....

The reinsurer

In terms of reinsurance, insurer that accepts the insurance from the ceding company is called ....

Retention Limit

The amount of insurance retained by the ceding company

Cession

The amount of insurance ceded to the reinsurer

Facultative Reinsurance

An optional, case-by-case reinsurance agreement between the parties

Treaty (obligatory) Reinsurance

The primary insurer is bound by obligation to cede insurance to the reinsurer is bound to accept the business

- All business that falls within the scope of the agreement is automatically reinsured

Pro rata

The ceding company and reinsurer agree to share losses and premiums based on some proportion

Excess method

The reinsurer pays only when covered losses exceeds a certain level

Quota-share treaty

The ceding insurer and the reinsurer agree to share premiums and losses based on some pre-determined proportion

Surplus-share treaty

the reinsurer agrees to accept insurance in excess of the ceding insurer's retention limit, up to some maximum amount

- sharing is dependent on face value of the policy

Excess-of-loss treaty

designed for protection against a catastrophic loss

- can be written to cover a single exposure, a single occurrence, or excess losses

Stop Loss Treaty

An XL treaty where the excess amount is determined by the sum of losses in a given period (generally within a year)

Reinsurance pool

An organization of insurers that underwrites insurance on a joint basis

- Each pool member agrees to pay a certain percentage

of every loss

- Each pool member pays for his or her share of losses

below a certain amount; losses exceeding that amount

are then shared by all members in the pool

What are the two ways reinsurers work?

Alternative Risk Transfer

ART stands for?

Financial Reinsurance

Contracts that are often highly customized and focus on financing aspects rather than the actual transfer of risk

Retrospective

Transfer of an insurance portfolio for the purpose of withdrawing from the business segment

Prospective

Management of an experience account that is debited by losses and gradually offset by premiums

Securitization of risk

An insurable risk is transferred to the capital markets through the creation of a financial instrument

Alternative Risk Transfer (ART)

Refers to the novel techniques and instruments for managing underwriting cat risks

Equity securities

In the event of a predefined cat, equity is available at an agreed premium

Interest-bearing securities

Cat bonds where investors lose the right to interest payments and/or parts of the capital provided in the event of a loss

Cat bonds

Corporate bonds that permit the insurer of the bond to skip or reduce the interest payments if a catastrophic loss occurs

Advantages of cat bonds

No moral hazard issues, independent of reinsurance markets, fast regulation

Disadvantages of cat bonds

High transaction costs basic risk, not very flexible

Equity put option

Option to increase capital at term agreed ex ante