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Risk (Traditional Definition)
Uncertainty concerning the occurrence of a loss
Risk (Better Definition)
A calculated possibility of a negative outcome
Calculated Possibility
A probabilistic outcome (chance of loss, likelihood of loss) that is known or estimated | Ranges from 0 to 1 (0% to 100%)
Negative Outcome
Loss (Must be Quantifiable (in $))
Frequency
How often does a loss occur? • The number of losses (such as fire, theft, collision) that occur within a specified time period. • Probability of a loss. • Ex: Probability of a fire is 0.0071 per loss exposure per year.
Severity
How much does it cost when a loss does occur? • The dollar amount of loss for a specific peril (fire, theft, collision). • Example: Average structure fire loss is about $25,000
Frequency Equation
Severity Equation
Total Losses ($) / # of Losses
Peril
Cause of Loss • Examples: Fire, windstorm, flood, collision, burglary, etc.
Hazard
A condition that creates or increases the frequency and/or severity of a loss. • Does not cause a loss. • Four types: 1. Physical 2. Moral 3. Morale (attitudinal) 4. Legal
Physical Hazard
A physical condition that increases the frequency and/or severity of a loss
Moral Hazard
The presence of insurance changes the behavior of the insured
Examples • Using a hammer to create “hail” damage to a roof. • Exaggerating the value of the insured property.
Morale (Attitudinal) Hazard
Carelessness or indifference to a loss, which increases the frequency and/or severity of a loss.
Examples: • Leaving car keys in an unlocked car. • Neglecting a tree limb growing over your roof.
Legal Hazard
Characteristics of legal system or regulatory environment that increase the frequency and/or severity of a loss.
Examples: • Juries in some jurisdictions are more sympathetic than other areas (meaning larger damage awards in liability lawsuits). • Georgia now requires Diminution in Value to be paid on property losses (meaning increased severity in Georgia).
Risk Classifications
• Pure Risk vs. Speculative Risk • Diversifiable Risk • Nondiversifiable Risk • Enterprise Risk • Systemic Risk
Pure Risk
Loss
No Loss
Ex: Auto Accident, Fire, Flood, Cancer, Slip & Fall
Speculative Risk
Loss
No Loss/No Gain
Gain
Ex: Investment, Gambling
Diversifiable Risk
Affects only individuals or small groups, not the entire economy.
• Can be reduced/eliminated through diversification. (Have multiple facilities, cloud/backup data centers) • Risks are not correlated (For example: 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 through diversification. • Government 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 an entire system or entire market due to the failure of a single entity or group of entities that can result in the breakdown of the entire financial system.
• Instability in the financial system due to the interdependency between the players in the market.
Major Types of Pure Risks
• Personal Risk • Property Risk • Legal Liability Risk • Loss of Business Income • Cyber-security
Personal Risk
Directly affects an individual or family; involves the possibility of loss of income, extra expenses, depletion of financial assets.
What perils might be involved? • Premature Death • Unemployment • Disability/Injury/Poor Health • Inadequate Retirement Income
Property Risk
The possibility of losses associated with the destruction or theft of property.
Direct Loss (Property)
Cost to repair or replace property damaged by a peril.
Indirect Loss (Property)
Financial loss resulting as a consequence of a direct loss.
Examples: • Fire damages your home, you have to pay to live elsewhere while it’s repaired. • Fire damages a business the firm experiences Business Interruption, Loss of Income, extra expenses et al.
Legal Liability Risk
Legal liability (financial consequences) resulting from injuries or damages you caused to someone else.
• 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 a direct physical damage loss, it is unable to generate an income.
• Is this a direct or indirect loss? • Example – Grease fire in the kitchen causes a restaurant to close down for 4 weeks while repairs are made. The restaurant has no income while closed, but certain expenses continue.
Burden of Risk On Society
• Larger Emergency Fund • Loss of Certain Good and Services • Worry and Fear
Techniques for Managing Risks
Risk Control
Risk Financing
Risk Control
Techniques to reduce the frequency or severity of losses
Risk Financing
Techniques for funding losses
Definition of Insurance
Insurance is the pooling of fortuitous losses by transfer of such risks to insurers, who agree to indemnify insureds for such losses, to provide other pecuniary benefits on their occurrence, or to render services connected with the risk
Basic Characteristics of Insurance
Pooling of losses
Payment of fortuitous losses
Risk Transfer
Indemnification
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 o But you could flip it 10 times and get 8 heads (80%). o The more times you flip it, the closer the percentage of heads will get to 50%.
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.
Fortuitous
unforeseen and unexpected by the insured and occurs a result of chance
Risk Transfer
Pure risk is transferred from the insured to the insurer, who typically is in a stronger financial position
Indemnification
The insured is restored to its approximate financial position prior to the occurrence of the loss
Characteristics of an IDEALLY Insurable Risk
Large number of exposure units.
Loss must be accidental and unintentional.
Loss must be determinable and measurable.
Loss should not be catastrophic.
Chance of loss must be calculable.
Premium must be economically feasible.
Large Number of Exposure Units
Enables the insurer to predict average loss based on the Law of Large Numbers.
• Large number of similar exposure units needed.
Loss Must be Accidental and Unintentional
Loss should be outside of insured’s control
Why? o Law of Large Numbers is based on randomness
Determinable Loss
Can you determine if a loss occurred?
Measurable Loss
Can you determine the amount of the loss?
Loss Should Not be Catastrophic (to the Insurer)
Allows pooling technique to work
Examples of catastrophes • Terrorism • Hurricane / Named Windstorm • Flood • Earthquake
Chance of Loss Must be Calculable
Must be able to calculate average frequency and average severity
Premium Must be Economically Feasible
Insured must be able to afford it
Adverse Selection
The tendency of persons with a higher-than- average chance of loss to seek insurance at standard (average) rates, which, if not controlled by underwriting, results in higher than expected loss levels
• Typically results from asymmetric information.
Asymmetric Information
Occurs when one party has information that is relevant to a transaction that the other party does not have.
Underwriting Risks
Process of selecting and classifying applicants for insurance
• Standards met • Coverage terms/exclusions to consider • Rates
Types of Insurance
Private Insurance Government Insurance
Private Insurance
Life, Health, Property & Casualty
Government Insurance
Social insurance programs
Life Insurance
Pays a death benefit to beneficiaries when an insured dies
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’s legal liability arising out of property damage or bodily injury to others
Casualty Insurance
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
Categories of Property & Liability Insurance
Personal Lines Commercial Lines
Personal Lines
• Private passenger auto • Homeowners’ “package” • Personal Umbrella Liability • Flood • Earthquake • Coastal Windstorm
Commercial Lines
• Commercial Auto • Workers’ Compensation • Commercial General Liability • Premise Liability • Products Liability • Commercial Umbrella / Excess Liability • Flood • Earthquake • Coastal Windstorm • Inland Marine / Ocean Marine • Surety Bonds • Fidelity Bonds / Employee Dishonesty • 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
Government Insurance – Social Insurance Programs Examples
Old-Age, Survivors, and Disability Insurance (Social Security)
Unemployment
Medicare
Other Government Insurance Programs
Found at both the federal and state level.
• Examples o Federal Deposit Insurance Corporation (FDIC) o National Flood Insurance Program (NFIP) o Fair Access to Insurance Requirements Plans (FAIR) o Beach and Windstorm Plans
Risk Management
Process that identifies loss exposures faced by an organization and selects the most appropriate techniques for treating such exposures
Pre-Loss Objectives to RM
• Efficient cost of risk • Permits better decision making • Meet legal obligations
Post-Loss Objectives to RM
• Survival of firm • Business continuity, earnings, growth • Societal
Steps in the Risk Management Process
Identify loss exposures.
Measure and analyze the loss exposures.
Consider and select the appropriate risk management techniques.
Implement and monitor the chosen techniques.
Step 1: Identify Loss Exposures
• What assets need to be protected? • What perils are those assets exposed?
Important Exposures
• Property • Liability • Business Income • Human Resources • Crime • Employee Benefits • Foreign • Intangible • Regulatory
Sources for Identifying Loss Exposures
• Meeting with management including risk manager • Financial statements • Loss history • Other firms/competitors • Risk management consultants • Surveys/questionnaires • Site Inspections • Review sales and purchase agreements • Flowcharts
Step 2: Measure and Analyze the Loss Exposures
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 more important.
Maximum Possible Loss (MPL)
the worst loss that could happen to the firm during its lifetime
Probable Maximum Loss (PML)
the worst loss that is likely to happen.
Step 3: Consider and Select the Appropriate Risk Management Techniques
Risk Control Risk Financing
Risk Control
Techniques that reduce the frequency or severity of losses
Risk Financing
Techniques that provide for the funding of losses
Risk Control - Avoidance
A certain loss exposure is never acquired (proactive), or an existing loss exposure is abandoned (reactive)
Risk Control - Avoidance (Advantage)
Frequency is reduced to 0
Risk Control - Avoidance (Disadvantage)
• May not be possible. • Usually has an opportunity cost. • Avoiding one loss exposure may create another.
Risk Control – Loss Prevention
• Measures that reduce the frequency of a particular loss. • Does NOT completely eliminate risk.
Risk Control – Loss Reduction
• Measures that reduce the severity of a loss. • No effect on the frequency of a loss
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.
Examples: • 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.
Examples: • Expanding customer base • Using multiple suppliers
Risk Financing - Retention
A firm or individual retains part or all of the losses that can occur from a given risk
• Retention level • Active • Passive
Retention level
the dollar amount of losses that the individual/firm will retain
Active
Deliberately retaining risk
Passive
Unknowingly retaining risk
When should risk be retained?
• No other option more attractive or available. • Worst possible losses are not serious (low severity). • Losses are predictable (high frequency; not catastrophic).
Risk Financing – Retention (Types)
• Unfunded; cash flow • Funded Reserve • Deductible • Captive Insurer • Self-Insurance Plan • Risk Retention Group / Group Captive
Risk Financing – Retention (Captive Insurance Company)
A captive insurer is 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 is an insurer owned by several parents
Advantages of a Captive Insurance Company
• Can help a firm when insurance is too expensive or difficult to obtain. • Lower Costs o No agent or broker commissions. o Interest earned on invested premium. • Easier access to reinsurance market. • Possibility tax advantages. • Possibility of favorable regulatory environment.
Self-insurance
A special form of planned retention by which part or all of a given loss exposure is retained by the firm
Risk Retention Group
• Group captives that can write any type of liability coverage except employers’ liability, workers' compensation, and personal lines.
• Exempt from many state insurance laws.
Risk Financing – Noninsurance Transfer
Methods other than insurance by which a pure risk and its potential financial consequences are transferred to another party.
Examples • Contracts • Leases • Hold-harmless agreements
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, et al) 4. Dissemination of information concerning insurance coverages. 5. Periodic review of the insurance program.
Deductible
A specified amount subtracted from the loss payment otherwise payable to the insured
Excess insurance
A plan in which the insurer pays only if the actual loss exceeds the amount a firm has decided to retain
Manuscript policy
A policy specially tailored for the firm.
Note
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