RMIN 4000 Exam 1 - Edmunds (wordier)

Risk

a calculated possibility of a negative outcome

Ex: Auto - UGA football accident after winning the natty

Risks of Auto Driving

Exposure: vehicle damange

Perils: accident

Risk Management: Drive safely

calculated possibility

a probabilistic outcome (chance of loss, likelihood of loss) that is known or estimated; Ranges from 0% to 100%

- 0% = impossible event (no risk)

- 50% = highest risk (most uncertainty)

- 100% = certain event (no risk)

Negative outcome

loss, must be quantifiable in $

- Ex: lare fire/auto accident - how much did you damage things?

Frequency

- How often does loss occur?

- The number of losses (fire, theft, collison) that occur within a specific time period?

- Probability of Loss

Ex: The probability of a fire is 0.0071 per loss exposure per year

Frequency = (# of losses)/(# of exposures)

Severity

- How much does it cost when a loss does occur?

- The dollar amount of loss for a specific peril (fire, theft, collison)

Ex: avg structure fire loss is about $25k

Severity = (total losses $)/(# of losses)

Peril

cause of loss

Ex: fire, windstorm, collision, flood, burglary, etc.

Hazard

condition that creates or increases the frequency and/or severity of a loss

- Does not cause a loss

4 Types

- physical

- moral

- morale (attitudinal)

- legal

Physical hazard

A physical condition that increases the frequency and/or severity of a loss

Ex: electrical outlets that are overloaded with things plugged into them

moral hazard

Dishonesty or character defects in an individual that increase the frequency and or severity of a loss/the presence of insurance changes the behavior of the insured

Ex: using a hammer to create “hail” damage to a roof or exaggerating the value of insured property

morale hazard

Carelessness or indifference to a loss, which increases the frequency and/or severity of a loss

Ex: leaving keys in an unlocked car or neglecting a tree limb growing over your roof

legal hazard

Characteristics of the legal system or regulatory environment that increase the frequency and/or severity of a loss

Ex: juries in some jurisdictions are more sympathetic than other areas (meaning larger damage awards reliability lawsuits)

Ex: Georgia now requires Diminution in Value to be paid on property losses (meaning increased severity in GA) - a Car getting into an accident

Pure Risk

loss or no loss - insurance is used to make you whole again

Ex: auto accident, fire, flood, cancer, slip and fall

Types: personal risk, property risk, legal liability risk, loss of business income, cyber-security (All relevant to both families and businesses)

Speculative Risk

loss, no loss/no gain, gain - outcome is uncertain

Ex: investment, gambling

Diversifiable risk

- Affects only individuals or small groups, not entire economy

- Can be reduced/eliminated thru diversification (have multiple facilities, cloud/backup data centers)

- Risks are not correlated (Ex: fire at multiple locations, theft, vehicle collision)

nondiversifiable risk

- affects the entire economy or large numbers of groups/persons within the economy

- Cannot be reduced/eliminated thru diversification

- Govt assistance may be needed to insure

- Risks are correlated (inflation, unemployment)

enterprise risk

Encompasses all major risks faced by a business firm:

- Pure risk

- Speculative risk

- Strategic risk

- Operational risk

- Financial risk

systemic risk

- Risk of collapse of entire system or entire market due to failure of a single entity or group of entities that can result in the breakdown of the entire financial systems

- Instability in the financial system due to the interdependency between the players in the market

Personal Risk

Directly affects individuals/family; involves the possibility of loss of income, extra expenses, and depletion of financial assets.

- Perils Invovled: premature death, unemployment, disability/injury/poor health, inadequate retirement income

- disability: Council of Disability Awareness Personal Disability Quotient (PDQ) Calculator

- Inadequate Retirement Income: Employment Benefit Research Institute Survey;

35% of retirees had household savings of less than $10k,

34% had never saved for retirement,

35% had household income of less than $35k,

Nearly half of retirees retired later than expected

Property Risk

the possibility of losses associated with the destruction or theft of property

direct loss to property

Cost to repair or replace property damaged by a peril

indirect loss to property

Financial loss resulting as a consequence of a direct loss.

- Ex: Fire damages your home, you have to live elsewhere while it's getting fixed; Fire damages business and the firm experiences Business Interruption, Loss of Income, extra expenses et al.

Legal Liability Risk

Financial consequences resulting from injuries or damages you caused to someone else.

- Ex: Defense costs

- No cap on losses (in most situations)

- Liens can be placed on income, assets seized

Loss of Business Income

- If a business has to shut down for a period of time due to direct physical damage loss, it is unable to generate income

- Is this a direct or indirect loss? - fire = direct, business income = indirect

Ex: grease fire in kitchen of restaurant causes shut down for 4 weeks while repairs are made

Burden of Risk on Society

- larger emergency fund

- loss of certain good and services

- worry and fear

Techniques for Managing Risk

1. Risk Control

2. Risk Financing

Risk control

Techniques to reduce the frequency or severity of losses.

Risk control: Loss prevention

Reduces frequency

Ex: airport security, employee safety training programs, protective equipment/clothing

- DOES NOT eliminate risk, but reduces frequency

Risk Control: Loss Reduction

reduces severity (fire and leak sprinklers)

- can occur pre-loss or post-loss

Risk Control: Avoidance

a certain loss exposure is never acquired (proactive), or an existing loss exposure is abandoned (reactive)

Risk Financing

techniques for funding losses

Risk financing: retention

retaining part/all of losses that can occur from given risk

- Active: deliberately retaining risk (choosing a high deductible)

- Passive: unknowingly retaining risk (not purchasing disability insurance)

risk financing: non-insurance risk transfer

By contractual agreement (hold harmless, indemnification)

- Hedging - derivatives such as options, futures, etc.

- Incorporation

Can be Bad when you are pushing the risk on another person who doesn’t have the insurance to deal with it

risk financing: insurance

transfer to an insurer in exchange for paying a premium

Insurance

the pooling of accidental losses by transfer of such risks to insurers who agree to compensate insureds for such losses, to provide other monetary benefits on their occurrence, or to render services connected with the risk

pooling of losses

The spreading of losses incurred by a few over the entire group

- Purpose is to reduce variation (as measured by standard deviation) which reduces uncertainty (risk)

- Think of standard deviation as the average distance from the mean

Ex: Football Hypothetical

Payment of fortuitous losses

Fortuitous = unforeseen and unexpected by the insured and occurs as a result of chance

- Is it fortuitous if you hit a bad shot on a golf course and your ball hits a house? YES!

- If you attempt to buy homeowners insurance when a hurricane is approaching, is a wind loss fortuitous? NO!

Risk Transfer

A pure risk is transferred from the insured to the insurer, who typically is in a stronger financial position

Ex: Banker wants insurance company to absorb risk for their house aka minimum deductible

Indemnification

The insured is restored to its approximate financial position prior to the occurrence of the loss.

Law of Large Numbers

The greater the number of exposures, the more closely will actual results approach the probable results expected from an infinite number of exposures

Example: A coin flip has a 50%/50% chance of heads

- But you could flip it 10 times and get 8 heads(80%)

- The more times you flip it, the closer the percentage of heads will get to 50%.

Characteristics of Ideally Insurable Risk

1) Large number of exposure units

2) Loss must be accidental and unintentional

3) Loss must be determinable and measurable

4) Loss should not be catastrophic

5) Chance of loss must be calculable

6) Premium must be economically feasible.

Large Number of Exposure Units

Enables the insurer to predict avg. loss based on the Law of Large Numbers

- Large number of similar exposure units needed

Ex: Honda and Toyota

- Can an insurance company insure things that they don’t insure a large number of?

Yes!

Loss must be accidental and unintentional

Loss should be outside of the insureds control

Why?

- Law of large numbers is based on randomness

- If the insured can deliberately cause a loss that the insurer covers (intentionally burn a house down), what is increased?

- Everyone’s rates go up!

Loss must be determinable and measurable

Determinable: Can you determine if a loss occurred? When might this be easy? Hard?

- Easy = car wreck, house fires, tree on house

- Hard = soft tissue injuries, pain and suffering

Measurable: Can you determine the amount of the loss? When might this be easy? Hard?

- Easy = fire happened, a construction contractor can come in and give an estimate of how much it is going to cost to rebuild

- Hard = pain and suffering is hard to quantify

Loss should not be catastrophic

allows pooling technique to work

Ex of Catastrophes:

- Terrorism

- Hurricane or named windstorm

- Flood

- Earthquake

Solutions for insurers

- Reinsurance: Will pay your loss, but will recover through other reinsurance companies

- Diversification: Instead of writing in just one state, they will expand into other states

Chance of Loss Must be calculable

Must be able to calculate average frequency and average severity

Why? - allows for comprehensive understanding of risk

Premium must be economically feasible

Insured must be able to afford it

Would the premium be economically feasible for a 99-year-old looking to buy life insurance?

- No!

Exceptions?

Adverse selection

The tendency of persons with a higher than avg chance of loss to seek insurance at standard (avg) rates, which, if not controlled by underwriting, results in higher-than-expected loss levels

- Typically results from asymmetric information

- Underwriters have technology

Ex: drones to look at houses to check roofs or if you have swimming pools

asymmetric information

Occurs when one party has information that is relevant to a translation that the other party does not have.

- Ex: If you are a smoker and don’t tell us, we aren’t going to pay

underwriting risks

process of selecting and classifying applicants (underwriting definition)

- Standards met

- Coverage terms/exclusions to consider

- Rates

Private Insurance

life, health, property and casualty

life insurance

pays a death benefit to beneficiaries when an insured dies (State Farm, BlueCross BlueShield)

health insurance

pays medical expenses because of sickness or injury (non-work-related injuries)

Property Insurance

indemnifies property owners against the loss or damage of real or personal property

liability insurance

covers the insured legal liability arising out of property damage or bodily injury to others

casualty insurance

a broad term that refers to insurance that covers whatever is not covered by fire, marine, and life insurance. Frequently it includes auto, liability, and workers' compensation

Personal Lines of Property and Liability

Personal Auto

Homeowners "package"

Personal articles

Personal umbrella liability

Flood

Earthquake

Coastal windstorm

Commercial Lines

- Commercial auto

- Workers compensation

- Commercial General Liability

Premise liability: happens on premise of company (getting hurt on campus)

Products liability: car seats, football helmets, the chicken example (things that get recalled)

- Commercial umbrella/excess liability

- Flood

- Earthquake

- Coastal windstorm

- Inland Marine/Ocean Marine: shipping on land/international (airline and ocean)

Surety Bonds: legally binding contract between three parties that guarantees one party will fulfill their obligations to another party

- Fidelity Bonds/Employee dishonestly

- Crime

- Cyber

- Others

Government Insurance

social insurance programs

- Financed entirely or in large part by contributions from employers and/or employees

- Benefits are heavily weighted in favor of low-income groups

- Eligibility and benefits are prescribed by statute

Ex:

Old-age, survivors, and disability insurance (Social Security), Unemployment, Medicare

- All of these come out of your payroll

Other Govt Progams

- Federal Deposit - Insurance Corporation (FDIC)

- National Flood Insurance Program (NFIP)

- Fair access to insurance requirements plans (FAIR)

- Beach and windstorm plans

- USDA Farm Programs

Risk management

Process that identifies loss exposures faced by an org and selects the most appropriate techniques for treating such exposures

- Risk Management Society (RIMS): society for all the risk managers in an area

Pre-Loss Objectives

Efficient cost of risk

- Not necessarily the cheapest option but we want the most efficient

Permits better decision making

Meet legal obligations

Ex: meeting EPA obligations, customer contracts

Post Loss Objectives

- Survival of firm

Ex: Purdue Pharma went into Bankruptcy due to selling opioids; goal is to not have this happen

- Business continuity, earnings, growth

Ex: have a plan to continue if some crazy event were to happen

- Societal

Ex: Delta - you want your workers to get home safely after a day of work, not die at your facilities

Steps in management Process

1. Identify loss exposures.

2. Measure and analyze the loss exposures.

3. Consider and select the appropriate risk management techniques.

4. Implement and monitor the chosen techniques.

Identify Loss exposures

What assets need to be protected?

- Brick and Mortar - inventory, vehicles, etc.

- Financial - extra expenses after loss to continue operations

- Human - workers, customers, and people coming to the site who could be injured

What perils are assets exposed to?

- Property

- Liability

- Business income

- Human resources

- Crime

- Employee benefits

- Foreign

- Intangible

- Regulatory

Sources for Identifying Loss Exposures

- Meeting with management including the Risk Manager

- Financial statements (SEC 10ks and 10Qs)

- Loss history

- Other firms/competitors

- Risk management consultants

- Surveys/questionnaires

- Site inspections

- Review sales and purchase agreements

- Flowcharts

Measure and Analyze Loss exposures

Measure and analyze

Measure loss exposure

- Estimate the frequency and severity of loss exposures

Frequency (probability) - How often does the loss occur?

Severity (outcome) - how much does it cost when a loss does occur?

Analyze

- Rank loss exposures according to relative importance

- Severity is important

Maximum Possible Loss (MPL) - the worst loss that could happen to the firm during its lifetime

- Tornado rips through and destroys the entire facility campus

Probable Maximum Loss (PML) - the worst loss that is likely to happen

- Fires - the warehouses are well prepared to stop fire quickly

Consider and select the appropriate risk management techniques

Avoidance, loss prevention, loss reduction, duplication, separation, Diversification

Risk Control: Duplication

Having back-ups or copies of important documents or property available in case a loss occurs

risk control: separation

Dividing the assets exposed to loss to minimize the harm from a single event

Example:

- Firewalls in buildings

- Have multiple data centers or warehouses

risk control: diversification

Reducing the chance of loss by spreading the loss exposure across different parties (customers, suppliers), securities (stocks, bonds) or transactions

Example:

- Expanding customer base

- Using multiple suppliers

When should risk be retained?

- No other option is more attractive or available

- Worst possible losses are not serious (low severity)

- Losses are predictable (high frequency; not catastrophic)

retention level

the dollar amount of losses that the individual/firm will retain

Retention Types

- Unfunded; cash flow

- Funded reserve

- Deductible

- Captive insurer

- Self-insurance plan

- Risk Retention Group/Group captive

Self-Insurance Plan

A special form of planned retention by which part or all of a given loss exposure is retained by the firm

- Disadvantage: Need to put up collateral

Risk Retention Group/Group Captive

Group captive that can write any type of liability coverage except employers liability, workers compensation, and personal lines

- Exempt from many state insurance laws

captive insurance company

an insurer owned by a parent firm for the purpose of insuring the parent firm’s loss exposures.

- Single-parent captive is owned by only one parent

- Association or group captive in an insurer owned by several parents

Advantages of Captive Insurance Company

- Can help a firm when insurance is too expensive or difficult to obtain

- Lower costs: No agent/broker commissions, Interest earned on invested premium

- Easier access to reinsurance market

- Possibility tax advantages

- Possibility of favorable regulatory environment

Risk Retention Group

can underwrite all types of liability risks except employer's liability, workers comp and personal lines

- must be owned by its insured

- exempt from many state insurance laws

Advantages of Risk Financing Retention

- Save on loss costs

- Save on expense

- Encourage loss prevention

- Increase cash flow

Disadvantages of Risk Financing Retention

- Possible higher losses

- Possible higher expenses

- Possible higher taxes

Risk Financing NonInsurance Transfer

Methods other than insurance by which a pure risk and its potential financial consequences are transferred to another party

Ex: contracts, etc.

Advantages of Risk Financing Non insurance Transfer

- Can transfer some losses that are not insurable

- Less expensive

- Can transfer loss to someone who is in a better position to control losses

Disadvantages of Risk Financing Non insurance Transfer

- Contract language may be ambiguous, so transfer may fail

- If the other party fails to pay, the firm is still responsible for the loss

Insurers may not give credit for transfers

Risk Financing Commercial Insurance

Appropriate for low-frequency, high-severity loss exposures

These areas must be emphasized:

1. Selection of insurance coverages

2. Selection of an insurer

3. Negotiation of terms and services (risk control, claims, etc)

4. Dissemination of information concerning insurance coverages

5. Periodic review of the insurance program

Deductibles

a specified amt subtracted from the loss payment otherwise payable to the insured

excess insurance

a plan in which the insureer pays only if the actual loss exceeds the amount a firm has decided to retain

manuscript policy

a policy specially tailored for the firm

Advantages of Risk Financing Commercial Insurance

- Firm is indemnified for losses; can continue to operate

- Uncertainty is reduced

- Firm may receive valuable risk management services

- Premiums are income tax deductible

Disadvantages of Risk Financing Commercial Insurance

- Premiums may be more costly

- Negotiation of policies takes time and effort

- Most policies are annual

- The risk manager may become lax in exercising loss of control

Hard Insurance Market

Insurer profitability is declining, underwriting standards are tightened, premiums increase, and insurance is hard to obtain

Soft insurance market

profitability is improving, standards are loosened, premiums decline, and insurance becomes easier to obtain.

Risk Management Policy Statement

Outlines the risk management objectives of the firm and the company policy with respect to treatment of loss exposures.

- provides standards for judging the risk managers performance

Implement and monitor the chosen techniques

- Successful risk management program requires active cooperation from many other disciplines within the firm

- The risk management program should be periodically reviewed and evaluated to determine whether the objectives are being attained

- The Risk Manager should compare the costs and benefits of all risk management activities

Benefits of Risk Management

- Enables a firm to attain its pre-loss and post-loss objectives more easily

- Society benefits bc both direct and indirect losses are reduced

- Can reduce a firm's total cost of risk

High Frequency, Low Severity

- funded reserve

- loss prevention

high frequency, high severity

- avoidance

- captive/risk retention group

- Loss prevention/reduction