RMIN 4000 Exam 1

Risk

Uncertainty about outcomes

has an upside and a downside

Peril

The cause of a loss (ex. a natural disaster)

Hazard

A condition that creates or increases the frequency or severity of a loss

Types of Hazards:

Physical: A physical condition

Moral

Morale

Legal: Certain characteristics of the legal system

Moral vs Morale Hazards

Moral: Dishonesty or characteristics of an individual that increase the chance or frequency of a loss

Morale: Carelessness or indifference to a loss because of the existence of insurance

Objective vs Subjective Probability

Objective: Long-run relative frequency of an event, based on hard date/historical frequency

Subjective: Personal estimate of the chance of loss

Fundamental vs Particular risk

Fundamental: Affects society at large

Particular: Affects individuals rather than society

Pure vs Speculative risk

Pure: Involves the possibility of loss or no loss

Speculative: Involves the possibility of loss, no loss, or gain

Diversifiable vs Non Diversifiable risks

Diversifiable: Risk can be minimized with a diverse portfolio

Non Diversifiable: System wide risk, cannot be minimized

Systemic Risk

When the risk of a loss threatens many, such as a bank that is too large to fail without hurting other banks

Pure Risks- Personal and Property risks

Personal: Risks to ones self (illness, death, unemployment, etc.)

Property: Risks to ones property (fire, flood, theft, etc.)

Direct vs Indirect Property Losses

Direct Loss: Loss that results from physical damage, destruction, or threat of property

Indirect Loss: Loss results from the loss of use of the property that is damaged destroyed, or otherwise lost for a period

Payment of Fortuitous Losses

Ideally, insured losses are entirely accidental

Pooling of Losses

Combination of risk exposure, based behind the law of large numbers. The greater the number of units, the more accurate expected losses of a single unit matches all units.

Basic characteristics of insurance

-pooling of losses

-payment of fortuitous losses

-risk transfer

-indemnification

Risk Transfer

Moving risk to one better equipped to deal with a loss

Indemnification

A legal agreement where one party agrees to compensate another party for future losses

7 Requirements of an Insurable Risk

-Large number of exposure units

-Accidental and unintentional loss

-Determinable and measurable loss

-Avoid great numbers of highly correlated risks

-Calculable distribution of losses (chance of loss, severity)

-Problems of adverse selection should be controlled

Economically feasible premium

Determinable and Measurable Loss

-Losses should have a definite cause, time, place and amount

-9/11 is a great example of when this standard was NOT upheld

What drove bankruptcy in the Harvard Health Insurance Example?

Adverse Selection

Catastrophic Loss

High correlation of single losses from a single catastrophic event can be dangerous for insurers

Ways of limiting exposure to catastrophic risk:

-Reinsurance

-Geographical spread of risk

-New “alternative” risk transfer tools

Adverse Selection

Occurs when an insured possesses info about certain risk increasing characteristics which the insurer does not know about

Can be reduced through additional screening

Risk Management Process

1. Identify loss exposures

2. Measure and analyze the loss exposures

3. Select the appropriate combination of techniques for treating the loss exposure

4. Implement and monitor the risk management program

How to measure loss exposure

-Loss frequency (probable number of losses during a time period)

-Loss severity (probable size of losses that may occur)

Risk Control

reduce the number of risks facing the organization or the amount of loss that can arise from these exposures

-Avoidance

-Loss Prevention/Reduction

Risk financing

Designed to guarantee the availability of funds to meet those losses that do occur

-Transfer

-Retention

Loss Prevention & Reduction

Can be done via:

-Duplication (creating back ups/spare copies of a critical asset)

-Separation (isolating/spacing apart risk exposures)

-Diversification (spreading risks across different, unrelated areas)

Active vs Passive Risk Retention

Active- Knowingly keeping a risk

Passive- Unknowingly keeping a risk (bad!)

Expected Value Strategy

Maximizes average outcome based on probabilities

Expected Utility Strategy

Maximizes personal satisfaction, weighing outcomes by preference

Minmax Regret Strategy

Minimizes maximum regret, focusing on avoiding worst case outcomes

Can you just look at expected value when weighing risks?

NO! It contradicts how some people actually behave.

People in general are risk adverse, this means…

They are often willing to accept a premium loading in order to be insured

As wealth increases…

risk aversion decreases

There are situations in which the ___ rather than the ___ should be the first consideration.

consequence (magnitude of potential loss) , probability

Do not risk more than…

you can afford to lose!