WK 5 - Insurance

How can we describe this risk?

• Binary outcomes (yes-1, no-0) the probabilities are likely conditional

• Continous outcomes (eg return next month on australian share)

• Australian shares monthly return has normal distribution - can describe using mean and standard deviation

• There is a lot of

variability (risk) of returns - 68% of the time return will be between -3.47% to 4.43%

Standard deviation relating to normal distribution for risk

• Small SD -> outcomes are close to the mean -> more predictable

• Large SD -> outcomes are spread out -> less predictable

How do you consider the decision for insurance?

• Size of the potential loss

• Size of probability of loss

• Combine these for expected loss?

Where do these probabilities for loss come from?

Subjective and objective

When thinking about risk and probabilities, research suggests

People dislike small losses more strongly than they like small gains - prospect theory

We weight probabilities inaccurately

• People tend to treat near certain events, and really small improbable events differently than just the objective probability

• People do not treat probabilities objectively

Different probabiltiies and peoples perception

• Actual probability is very small - people overestimate it

• Actual probability is near certain - people underestimate it

Risk types

• Some risks within your control

  • Eg car accident from your speeding

• Some are not

  • Eg meteorite falling on car

• Some risks expose you to loss only -> pure risk (eg disasters)

• Some risks give you a loss or gain -> speculative risk (eg investments)

Risk management 4 stages

1. identification of potential risks

2. evaluate/quantify the potential losses

3. management strategy of identified risks

4. program reveiw

Step 1: Identification of risk

• risk to human capital (unemployment, health)

• risk to assets (physical, financial)

• risk to liabilities

Step 2: evaluation of personal risks

financial cost can be estimated:

• Event (cost of transfer to hospital, medical surgery)

• Ongoing (rehabilitation costs, lost income, medicine)

• Location can be important eg while travelling: transfers, additional costs

Personal risk management - how to quantify loss?

Find the present value of a series of cash flows using income and discount rate

Step 3: management strategy of identified risks

1. Assess strategies: control (avoid), transfer, finance, minimise risk?

2. Implement strategy

control measures for risk

• Health: lifestyle factors, diet, smoking, alcohol

• House: smoke detectors

• Car: drive conseveratively

• Emergency fund for many risks

Management strategy: transfer risk

financial responsibility passed to another party - typically via insurance

program reveiw

periodically reassess to ensure ongoing risk, protection

Insurance is a central part of

risk transfer & financing measures

Types of insurance policies include

• Life insurance policies

• Disability policies

• Trauma policies

• Health insurance policies

• Income protection insurance

• Car

• Health

• Pet

Insurance people arent doing this with the kindness of their heart - they are

doing this with a profit motive

You can retain some risk & reduce premium via

excess - what you must pay of a claim

Life insurance

• If you die early, your future income disappears - your family loses that income stream

• Life insurance: replaces that lost income

Therefore what is life insurance protection against

loss of human capital

features of term life insurance

amount insured, policy duration, premiums (stepped, level)

Life insurance often bundle other insurances:

• Total & permanenet disablement insurance (TPD)

• Total & temporary disablement insurance (TTD) aka income protection

• Trauma insurance (eg heart attack, stroke, cancer)

Income protection insurance

• Not for the chance you lose your job

• For when illness or injury prevents you from working

What does income protection insurance vary by?

• how long you have to wait to claim

• How much you get paid (generally up to 75%)

• How long you get paid

• Normally tax deductible

highest degree of honesty imposed on both. Recently amended obligation for insured

• Duty to take reasonable care not to make a misrepresentation (duty not to mislead)

• Failure to meet duty may void contract or

• Reduction in insurer liability upon a subsequent claim

Misrepresentation of information provided by insured may be categorised as being either

• Innocent (option to void by insurer)

• Fraudulent (contract void from start)

Management strategy: retain risk

losses met from own resources or via insurance excess