insurance and risk management

for fbla

risk

• uncertainty, no idea what will happen for sure

• includes losses for individuals and businesses

• reduction in value, ex. money

pure risk

• losses can be known with certainty

• NO uncertainty

• loss is still present; no uncertainty about the loss

  risk does not equal loss!

probability

• probability is the number of how likely the event is likely to occur

• ranges from 0%-100%

• risk does not equal the probability of a loss

types of risk (1)

pure vs. speculative

types of risk (2)

static vs dynamic

types of risk (3)

diversifiable vs. non-diversifiable

types of risk (4)

objective vs subjective

pure vs speculative risk

• both involve uncertainty

• difference is the outcome

pure risk

• 2 future outcomes: loss or no loss

• associated losses are typically insurable

speculative risk

• 3 future outcomes: loss, gain, no gain or loss

• basis for enterprise resource management

• businesses/organizations face more speculative risk than pure risk

• many speculative risks are not able to be insured; ones that are will be difficult/expensive

static risk

• does not change significantly over time

• risk is always present for organizations, society, and individuals

dynamic risk

arises out of changing circumstances

diversifiable risk

• not highly coordinated

• random; not dependent on other factors

• impacts only some individuals/businesses/groups

non-diversifiable risk

• highly correlated

• simultaneous occurrence of loss from a single event

• impacts large segments of society at once

subjective risk

• an individual view on uncertainty/situation involving risk

• depends on the individual

• not easily measured/not easy to compare

• influences how firms/decision makers handle risky situations

expected loss

based on experience, data, or other means (what we expect to happen)

actual loss

losses that actively occur

factors affecting risk

peril, frequency, severity, hazard

peril

the immediate cause of the loss

frequency

• how often do the losses occur?

• # of losses in a given period of time

• cannot be negative

what is the likelihood of loss?

• low frequency losses - low probability loss

• high frequency losses - high probability loss

severity

• how bad a loss is in $$ terms

• severity is conditional upon frequency being positive

• if frequency is 0, severity is not an issue

hazard

• underlying condition behind a loss occurrence

• either increases frequency, increases severity, or increases both

three types of hazards

physical, moral, and morale

physical hazard

1) location

if peril is flood, living at the shore is a physical hazard

2) construction

fire peril, wood structure is a hazard

3) use

fire peril, use of a building as a church is a hazard

moral hazard

• behaving differently because of insurance

• frequency/severity increases because of insurance

  ex: insurance fraud, arson, etc.

• common thread: presence of insurance, change in moral behavior

• fixed prices lowers user cost

• lower price, increased demand

• costly activity

morale hazard

• carelessness concerning losses

• has nothing to do with the existence of insurance

decision-making process

• manage pure (TRM) and speculative (ERM) risk

• goal for TRM is to minimize financial impact

• goal for ERM is to maximize shareholder value

risk management in an organization

• originally specialized area of finance

  1) finance department (small)

  2) risk manager (medium)

• 3) chief risk officer (large)

• continuously evolving

• not only insurance buying

evolution of risk management

1950's- no such thing as risk, just bought insurance. very narrow and nonstrategic

60’s - professor wayne snider at temple helps coin term risk management and it becomes a strategy

present - very important function & broad

steps in the risk management process

1. Identification of exposures to loss

2. Evaluate exposures to loss

3. Identify possible alternatives

4. Select among the alternatives

5. Implementation of the chosen options

6. Re-evaluate periodically the chosen strategies

objective risk

• measurable variation in uncertain outcomes based on facts/data

• variation of actual from expected outcomes

• more variation means more risk

if you have 2 identical firms but one firm faces more risk than the other, which one has more value?

the firm with the least risk

• implication is that risk creates an economic burden

concept: risk is "costly"

• does risk cost an organization?

• how does that impact society?

• how does it impact the organization?

expected cost of loss

money that comes from losses

ex: - death of a family member - loss of financial support

• cost of hospital stay/healthcare services

• income lost from businesses

cost of manage/risk management expenditures

money spent to prevent the loss

ex: - PPE equipment - mask

• money spent to make places safe; bulletproof glass, outdoor heating, etc.

• money spent on vaccines such as research and development

damage to society/loss of goods or services b/c of risk

• deemed “too risky”

• society loses valuable

• people lose their jobs

• economy suffer, high unemployment

• can't do things you enjoy doing - eating out, travel, see loved ones, etc.

traditional risk management (TRM) loss exposures

• property losses

• net income

• personnel

• liability

property loss exposure

loss ownership of financial/physical assets

theft/damage

• direct losses

• cost of replacing the asset

• cost of repair

legal interest

• financial interest or stake in the property

• if there is a loss to the property, you also suffer a loss

situations giving rise to interest in property

1. ownership interest

2. secured creditors

3. buyers and sellers interest

4. bailee interest

5. tenant interest

6. leasehold interest

ownership interest

• most common types of interest

• can have present or future ownership interest (future ex: when you have a car loan or mortgage)

secured creditors

• the bank or lender when you take a loan for a house

• they actually hold title - i.e they hold title - your ownership interest is future

buyers and sellers

shipping products

bailee interest

• a bailee is an entity who receives property from another for a business purpose

• a bailor is the owner of the property

• interest for the bailee is a legal liability to return or cost to replace the property - if something happens before returning it to the bailor

tennant interest

• continued use interest

• for a specific period of time

• for a specific purpose

• for a specific rental rate

• responsibility to return property in reasonable condition

• may have leasehold interest

leasehold interest

ex) - 10 yr property lease

• $1000/month

• yr 5, fair market value of rent is $1500

• fire destroys the building

• tenant leasehold interest they hold

• leasehold interest exists for tenant if the fair market value is more than rent

net income loss exposures

• AKA business interruption

• net income = revenue - expenses

• a firm suffers a primary (usually property) - as a result suffers a secondary loss that results in indirect expenses

indirect losses: extra expenses, loss of income

• normal procedures of a business are interrupted

• decrease in revenue

• increase in expenses

• impacts bottom line (net income)

events causing net income losses

• damage to property owned by the firm

• delivery truck is stolen (property loss)

• extra costs

• rent another truck causing an increase in expenses

• ordered are not filled causing a decrease in revenue

• damage to property owned by others

• key supplier has a property loss

• unable to produce goods causing a decrease in revenue

• power or telephone outage

• could causes a decrease in revenue

personnel loss exposures

• risk that organization will suffer losses due to key employees suffering a loss

• employee suffers illness, death, disability, retirement, resignation, etc.

• for the employees suffering loss - human capital risk

• employee benefits and personal finance issues

• due to loss of key employee - the firm may also suffer: revenue decrease, sales are down, decisions are not made, expenses increase, cost of replacing the person

• personal issue becomes a business issue for employer negligence and legal liability

• wealth losses from liability exposure

• money loss from being sued

• legal fees

• bad behavior or breaking a contract can lead to a lawsuit

• behavior commonly classified as either:

  • intentional (assault, libel, slander)

  • unintentional (negligence or carelessness)

legal liability is established when:

• there was negligence

• there was actual damage/loss

what constitutes negligence

• failure of a person to exercise the proper degree of care

• burden of proof is on the injured party

absolute/strict liability

• L.L. is established because accidents happen

• imposed whether anyone was at fault

• situations w/ children, workers compensation

measurement issue

• usually easy to establish injury or damage occurred

• establishing the amount of damage is usually difficult

measurement of losses

• property losses

• relatively simple to calculate

• bodily injury (BI)

• special damages

• compensate for measurable losses

• medical expenses

• loss of income

• moderately difficult to calculate

measuring bodily injury damages

general damages

• compensate for intangible losses

• pain and suffering

• mental anguish

• difficult to measure/estimate punitive damages

• amounts assessed as a form of punishment

• gross negligence is involved

• very difficult to estimate and measure

defenses to liability

• assumption of risk defense (by injured party)

• one recognizes the dangers involved in an activity

• voluntarily chooses to encounter if:

  • attending a hockey game

  • going skydiving

• comparative/contributory negligence

  • plaintiff was partially to blame for what happened

res ipsa loquitur

• not strict liability

• "the thing speaks for itself" - a modification to a law of negligence

• presumption of negligence on part of defendant

• requirements:

  • normally would not occur unless negligence

  • defendant exclusively controls the tools/equipment

  • injured party does not contribute to loss

  • ex: dentist removes the wrong tooth

vicarious liability

• one person becomes L.L. for the negligent behavior of another

• employees are held responsible for actions of their employees acting within the capacity of employees

joint and several liability

• negligence of two or more parties contributes to the injury or damage

• injured parry may recover the entire amount of compensation from any negligent party who is able to pay - regardless of the degree of the party's negligence

• “search for deep pockets”

product liability

• manufacturers of a faulty product that injures someone or damages property may be held L.L.

• negligence

• product is negligently made or improperly designed

• proper warning is not given to the consumer

product liability losses

• cost of defending and paying claims for injury

• cost of recalling any batches of products that are suspected of being defective

• damage to your name

premises liability

• owner or tenant may be held liable for damages if someone is injured

• if the property of others is damaged as a result of a condition in or arising out of the premises

trespasser

someone who comes without right and consent - only obligated to abstain from doing intentional harm

licensee

• comes onto property with knowledge of owner

• no purpose of or benefit to owner

• must warn of any hidden danger

social guests/invitee

• been invited for some purpose

• customer in store

• must keep premises safe so no harm comes

liquor liability

businesses that manufacture, sell, and serve alcohol

• injuries resulting to patrons/guests from selling alcohol

• DRAM shop laws- can hold businesses liable if they overserve someone and they subsequently leave and injure someone

• 30 states have DRAM shop

• rest have social host liability, where it typically only resides with the serving of someone who is underage

animal liability

• exotic animal

• strict liability

• dogs

• some states have strict liability

• some states - if dog never bit before, could escape liability

traditional risk management

• 4 loss exposures (property, net income, personnel, liability)

• silo approach

• focus on mostly insurable risks

silos

• property/liability pure risk (hazard risk) - risk manager

• personnel risk - human resources

• operation risks - COO/business units

• financial risk - CFO

• strategic risk - CEO/board of directors

enterprise risk management

manage risk and seize opportunity

• risk-based approach to managing an enterprise

• very strategic, holistic, scientific approach

• breaks down into 4 quadrants of risk

#1 - hazard risks

• fire/floods - property

• issues w/ key employees - personnel

• lawsuits - liability

• net income losses

• typically pure risks

#2 - financial risks

• inflation

• foreign exchange rates/currency

• stock market

• interest rates

• volatility

• liquidity

• credit

• debt rating

most are speculative risks, not net income losses

#3 - operational risks (risks that arise out of business operations) *combination of pure/speculative risks

• manufacturing products

• supply chain issues

• service provider failures

• system failures

• products retail

• regulatory issues

• employment practices/company policies and procedures

• discrimination

• workplace violence/sexual harassment

strategic/business risk (SWOT)

• customer service issues

• public relations

• reputation

• competition

• bad business decisions

• intellectual property

• ethics

• union issues

• typically, speculative risks

TRM

• TRM has silo/departmentalized approach

• TRM focuses mainly on hazard type risks (flood, fire, etc)

• handled by risk management area

• financial type risks handled by CFO, finance, or accounting

• other risks maybe handled by their specific areas

• not much effort to make relative comparisons among various risks to understand the cumulative impact on a firm

ERM

• has an integrated approach

• occurs at an enterprise level instead of individual departments

• risk management activities heavily impact business decisions

• designed to facilitate comparison and evaluation

• identify risks and determine if risks are correlated or independent

CRO - chief risk officer

• change business strategy

• seize opportunities

• CRO is critical

how to identify exposures - 1

inspections of plant/facility/location - "walk-arounds"

how to identify exposures - 2

contract analysis

• leases

• hold harmless agreements

how to identify exposures - 3

look at past info

• doesn’t work in all situations

• doesn’t work w/ dynamic risk

how to identify exposures - 4

share loss information with similar organizations

how to identify exposures - 5

safety checklist from insurance companies

how to identify exposures - 6

flow chart approach

how to identify exposures - 7

ask employees/managers in the firm

how to identify exposures - 8

financial statement approach

• balance

• assets

• physical-building

• non-physical - trademark, patent, copyright, goodwill

• liabilities

• who owes us money? can they pay?

• income statement

• sources of revenues

• where does it come from?

• budget

measure and evaluate exposures to loss

• step 2 in the risk management process

• measure

• probability of a loss (frequency)

• $$ amount of losses that do occur (severity)

• expected outcomes/loss = EL = E(F)*E(S)

• total $ of losses in given time period (frequency and severity - expected loss)

• risk

• uncertainty

• variation around expected losses vs actual

statistical probability

• make estimates based on statistics

• look at past data and estimate or run an experiment and use results from the collected data

• law of large numbers

law of large numbers

overtime the more data you collect or more observations that occur- your results will get closer to the accurate result

random variables

• - outcome depends on some chance event

• the results are random

• the rolling dice (1 out of 6)

• coin flip (heads or tails)

• car accidents

• property fires

expected outcome

the core of risk management decision making

uses of expected outcome

serves as a basis for for enterprise risk management decisions and insurance company pricing decisions

gross premium

premium paid per unit of coverage to insure a particular risk

• price for product

• price should be sufficient to cover all costs

• insurer does not know all the costs until final insurance claim is settled

3 components of gross premium

pure premium + risk charge + administrative costs

pure premium

portion of the gross premium calculated as being sufficient to pay for losses only (expected outcome)

• expected outcome must be estimated in advance

• estimate of EO may be wrong

• actual losses may not be equal to expected outcome

actual loss = expected loss

break even

actual loss < expected loss

profit

actual loss > expected loss

loss

risk charge

reflects the estimation risk of the insurer

• extra amount charged by the insurer to represent the estimation risk

• insurers use past information to predict the future