Risk Management Chapter 7: Market Failures Relating to Managing Risk, Risk Pooling, and Optimal Risk Pools

Risk Pooling

-Adding another person to the risk pool lowers the insurers risk even though EO is doubled

-Risk pool must be large and homogeneous

-As the risk pool gets larger and larger, the risk faced by the insurer falls and approaches zero

-Direct result of the LLNs

-Allows the risk transfer to exist and be of economic benefit

-Facilitates the risk transfer

Definition of Insurance

Insurance is a device that:

-Pools exposures to loss of individuals into a group

-Uses funds paid by members of the group to pay for losses as they occur

-Group is engaged or involved in a loss or risk sharing arrangement

Income/Wealth Transfer in Risk Pool

-All risk pools shift money around

1) Homogeneous Risk Pool

2) Heterogeneous Risk Pool

1) Homogeneous Risk Pool

Income transfer is from those who do not have loss to those who do have a loss

2) Heterogeneous Risk Pool

-Income transfer is from those who do not have loss to those who do have a loss

-Income transfer is from low-risk individuals to high-risk individuals

-Transfer between risk classes

-Social Security is Largest Risk Pool in U.S: This has an intergenerational risk/wealth transfer. Is is very heterogeneous.

Risk or Loss Sharing

Why do Firms and Individuals Purchase Insurance? What is the Commodity Purchased?

-Certainty

-Peace of mind

-Enhances credit worthiness

-Protection of assets

Trade an unknown/uncertain loss without insurance for a known/certain loss with insurance

-Premium can be viewed as known loss (probability = 1)

-Certainty in loss costs

Individual risk still exists (just financial risk is reduced)

Insurance Involves

-pooling & transfer

-risk transfer from the insurED to the insurER

-transfer the financial responsibility for payment of a loss to the insurer

How/Why is the Insurance Company Able to Accept Risk Transfer?

-Obtain data over the years of offering insurance - information is POWER and their predictions are more accurate - less risk

-Insurance company invests money until they pay claims!

Insurance Contract Indemnification

-Indemnification

-indemnify

-Full Indemnification

-Partial Indemnificaiton

Indemnification

Insurer agrees to indemnify the insured in the event of a loss

Indemnify

-To compensate

-Insurance is a contract of indemnity.

Full Indemnification

-All losses are paid for no matter how large or small

-Place the insured in the same financial position after the loss as they were prior to the loss

-Is insured always indemnified? NO

Partial Indemnification

-Cost sharing and partial insurance

-Cost sharing: Deductible/ copay/ coinsurance - auto, homeowners, health insurance

-Insurer agrees to indemnify the insured in the event of a loss

-Forms of indemnification:

1) Replace or repair an asset

2) Cash-reimburse or pay dollars (before or after loss)

3) Provide services - such as an attorney (liability)

Principle of Indemnity

-In the event of a property loss, the insured should not collect more than the actual cash value of the loss (ACV)

--ACV is simply a way to value or measure a loss

--Limit the "amount of recovery"

-**ACV = Replacement Cost - Depreciation based on Replacement Cost

-Purpose: To control moral hazard

--Prevent the insured from making a profit from the loss

-Violations to the Principle:

1) Life Insurance: ACV rule has no meaning

2) Insurance for Rare Items: "One of a Kind" Specify the amount of potential loss payment before it occurs

What Tool Do We Use and When?

Depends on Frequency and Severity

Insurance Supply

-Insurers are willing to sell insurance at a particular price

-GP (Gross Premium) = Price of Insurance

-GP = Expected Losses + Risk Charge + Admin (Loading)

Insurance Demand

-Will individuals pay for insurance at the stated premium?

-Pmax = most an individual will pay for insurance for a particular risk

-A risk is insurable if...

-Pi < Pmax - a market exists

Why Might Pi > Pmax?

Pi is too high

-expected losses are too high

-risk charge is too high

-loading costs are too high

Pmax is too low

-individuals underestimate the severity or frequency of the loss

-moral hazard created by disaster relief (floods) - where insurance like benefits exist

Characteristics of an Insurable Risk

-5 ideal situations that the insurance company seeks when determining if a risk is insurable

-It is a wish list - not required that all are met

-Guidelines

-What do we need for a market for insurance to exist, so a risk is insurable?

1) Large number of similar objects

2) Losses are accidental or unintentional

3) Losses can be determined and measured

4) Losses not catastrophic to insurer

5) Large loss principle

1) Large number of similar objects

-life insurance

-automobiles

-nature of objects similar so reliable statistics can be formed

-also need to be concerned with *adverse selection*

Adverse Selection

-AKA: Anti selection or negative selection

-Demand correlated to risk

-Information is only known to insurED

-Impact on price could lead to collapse of insurance pool, product, or market

2) Losses are accidental or unintentional

-need to be fortuitous in nature

-must be some uncertainty or no risk

-insured should have no control over increasing frequency or severity

-must be accidental

-avoid moral hazard & gambling

-why a problem?

-expected losses go up

-Pi goes up

-Pi > Pmax

-solutions?

-Deductible or co-pay

-Claims investigations

-Policy limits

3) Losses can be determined and measured

Did loss occur?

-not always easy for insurer to determine

What are losses?

-how do we measure "pain & suffering"?

4) Losses not catastrophic to insurer

-Catastrophic to insured: ok

-Normally one random event - one claim

-When one random event - results in many, many losses - Big Problem

-Earthquake, flood, hurricane - risks that are difficult to diversify

-Avoid having all members of group suffer loss at the same time

Loss Should Not Be Catastrophic to Insurer

-Creates the risk of insolvency for insurer

-Difficult for insurer to predict overall cost

-Risk charge goes up

-Pi goes ip

-Pi > Pmax

-Law of Large Numbers assumes that random events in question are independent events

Loss Not Subject to Catastrophic Loss

-Solutions for catastrophic risks include

-Good underwriting

-Diversify risks

-Reinsurance

5) Large loss principle

-maximum possible loss needs to be sufficient

-administrative/ loading costs too high for it to be affordable

-small losses better off paid through savings

Insurance Contract Issues

-Misrepresentation: false statement made by Applicant or when filing claim - Insurer can deny

-Concealment: must provide important or relevant information to the insurer

-If you don't - insurer can deny

-Your job to know

Principle of Subrogation

-substitution of insurER for insurED

Example:

-driver A hits driver B

-driver B has medical expenses & lost wages

-driver B collects damages from insurer B

-insurer B sues driver A or driver A's insurance company to collect damages paid to driver B

-substitution takes place

-hold negligent 3rd parties at fault

-control moral hazard

-insured can not impair insurers right to subrogate

-an insurer can keep proceeds from subrogation only after their insured has been fully indemnified

Subrogation Proceeds Example

-damages to driver B = $8,000

-indemnified from insurer B = $7,000 ($1,000 deductible)

-proceeds from subrogation = $8,000 for insurer B

-must give first $1,000 to driver B -fully indemnified

-insurer keeps only $7,000

Public Policy Issues

1) Terrorism

2) Flood

1) Terrorism

-2002

-9/11 and the new terrorism exclusion on policies now creates a demand for terrorism coverage

-insurance companies do not want to sell it / they stop selling it

-TRIA (Terrorism Risk Insurance Act) was created to serve as a backdrop for insurers to offer coverage

-Allows the economy to recover and business to feel secure that coverage can be acquired

TRIA 2002

-Was originally designed for 3 years and expired at the end of 2005

-Was modified at the end of 2005 and extended by 2 years

-Extended again in 2007, 2015, and 2020

-Current version runs through the end of 2027

Purpose of TRIA

- Terrorism too unpredictable for insurers to properly price the exposure

- Emerging risks difficult to price

- Government theory was over time, private insurance market forces could eventually handle

- It has not occurred, necessitating the ongoing extensions

- Essentially, the government backs up or reinsures the terrorism risk for insurance carriers

- Won't allow insurers to get wiped out from one catastrophic loss

2) Flood

-Insurance companies don't want to sell flood insurance

-too common & too catastrophic

• every state in the US has experienced a flood

• can't properly diversify

-Insurance companies sell it on behalf of the federal government

-US government accepts all the risk

-Premiums are subsidized by the government

• people pay far less than they should

-Tax payers essentially subsidize people living in flood zones

-Currently the program is $21 Billion in deficit

-Despite the subsidy and losses - the coverage is not broad

• evidence that it is uninsurable

Loss Control

- Proper grading

- Sump pump

- Trench drain

- Waterproof paint

- Properly maintained gutters

- Commercial structures—generators and electrical equipment on roof as opposed to basement