RMIN 4000 - Exam 1

Exposures

Things of value (assets) that could be lost

Perils

• Things that could happen to these assets

• The cause of loss (fire, tornado, burglary)

Risk Management

What do you do to protect these assets and reduce losses

Risk

A calculated possibility of a negative outcome

Calculated Possiblity

• A probabilistic outcome that is known or estimated

• Ranges from 0 to 1 (0% to 100%)

Negative Outcome

A loss & must be quantifiable ($)

Frequency

• How often does a loss occur

• Probability of a loss

Frequency Equation

Number of Losses / Number of Exposures

Severity

How much does it cost when a loss does occur

Severity Equation

Incurred Losses($) / Number of Losses

Frequency & Severity Example:

Lannister Insurance Company insures 100,000 homes. In 2024, they incurred a total of $30,000,000 in wind damage
losses to the owners of 5,000 of those homes.
- What was Lannister’s wind loss frequency in 2024?
- What was Lannister’s average wind loss severity in 2024?

Frequency = 0.05

Severity = 6,000

Hazard

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

• Does not cause a loss

The Four Types of Hazards

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

• Ex: Using a hammer to create “hail“ damage to roof, exaggerating the value of insured property

Morale (Attitudinal) Hazard

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

• Ex: 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 increases the frequency and/or severity of a loss

• Ex: Juries in some areas are more sympathetic that other areas, GA requires Diminution in Value to be paid on real property losses (increased severity in GA)

Risk Classifications

• Pure v. Speculative Risk

• Diversifiable Risk

• Nondiversifiable Risk

• Systemic Risk

Pure v. Speculative Risk

You can buy insurance for pure risks but not speculative risks

Diversifiable Risk

• Affects only individuals or small groups, not entire economy

• Can be reduced/eliminated through diversification

• Risks aren’t correlated (fire, theft)

Nondiversifiable Risk

• Affects the entire economy or large number of groups within the economy

• Cannot be reduced through diversification

• Government assistance may be needed to insure

• Risks are correlated (inflation, unemployment)

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 players in the market

  • Millennium Bridge in London Ex.

    • Started swaying from a large gust of wind that made everyone react to it and start walking the same way

    • "Individually you do what's right for you, but when everyone does it collectively that's what creates systemic risk"

Major Types of Pure Risks

• Personal Risk

• Property Risk

• Liability Risk

• Loss of Business Income

• Cyber-Security

All are relevant to individuals & families and businesses

Personal Risk

• Directly affects and individual or family; involves the possibility of loss of incomes, extra expenses, depletion of financial assets

• What perils might be involved

  • Death, unemployment, disability, inadequate retirement income

    • Rule of 72: 72 / % = years it will take to double

Property Risk

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

  • Direct Loss: Cost or repair to replace property damaged by a peril

  • Indirect Loss

    • Financial loss resulting as a consequence of a direct loss

    • Ex: After fire damages your home, you have to pay to live elsewhere while it's repaired

Liability Risk

• Legal Liability (financial consequences) resulting from injuries or damages you caused to someone else

• No upper limit

• Liens can be placed on income, assets seized

• Defense Costs - lawyers are expensive

Loss of Business Income

• If a business has to shutdown for a period of time due to a physical damage loss, it is unable to generate an income

• Indirect loss

Techniques for Managing Risks

Risk Control & Risk Financing

Risk Control

Techniques to reduce the frequency or severity of losses

• Loss Prevention

  • Reduces frequency

  • Airport security, safety training programs

• Loss Reduction

  • Reduces severity (fire sprinklers)

  • Can occur pre-loss or post-loss

• Duplication, Separation, & Diversification

• Avoidance

  • A certain loss exposure is never acquired (proactive)

  • An existing loss exposure is abandoned (reactive)

Risk Financing

Techniques for funding losses

• Retention (if occurs, pay for out of pocket)

  • Retaining part or all of losses that can occur from a given risk

    • Active: Deliberately retaining risk (choosing a high deductible)

    • Passive: Unknowingly retaining risk (not purchasing disability risk)

• Noninsurance Transfer

  • By contract

  • Incorporation

• Insurance

Textbook Definition of Risk Management

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

Loss Exposure

Any situation or circumstance in which a loss is possible, regardless of whether a loss actually occurs

Steps in the Risk 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

Step 1: Identify Loss Exposures

• What assets need to be protected?

• What perils are those assets exposed to?

• Most important step

  • If you haven't identified the loss exposure, then you're stuck paying for it

(passive retention)

• Sources for Identifying Loss Exposures: Loss history, financial statements, other firms/competitors, risk managers consultants, surveys, inspections, contract analysis

Step 2: Measure and Analyze the Loss Exposures

• Measure

  • Estimate the frequency and severity of loss exposures

  • Frequency (probability) - how often does it 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 - 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

  • Avoidance, Loss Prevention, Loss Reduction, Duplication, Separation, Diversification

• Risk Financing

Avoidance

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

• Advantage - Frequency is reduced to 0

• Disadvantages - May not be possible, usually has an opportunity cost, avoiding one loss exposure may create another

Loss Prevention

• Measures that reduce the frequency of a particular loss

• Does not completely eliminate risk

Loss Reduction

• Measures that reduce the severity of a loss

• No effect on the frequency of a loss

Duplication

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

Separation

• Physically separating something, dividing the assets exposed to loss to minimize the harm from a single event

• Ex: Firewalls in buildings, companies with multiple warehouses, president and VP can't fly on the same plane

Diversification

• Spreading the risk across multiple parties, securities, or transactions

• Ex: Nike branching out from just shoes

Retention

• Deductible means retention

• A firm or individual retains part or all of losses that can occur from a given risk

  • 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?

  • It is difficult to insure

  • Worst possible losses are not serious (low severity)

  • Losses are predictable (high frequency)

• *Risk Manager needs to evaluate all potential costs before choosing retention as a risk management technique

Unfunded Retention

Don’t have money aside

Funded Reserve

Actively putting money to the side

Deductible

The amount that you are responsible for in the event of a loss when you have insurance

Captive Insurer

• A business creates its own insurance company

• A single-parent captive is owned by only one parent

• Association/Group captive is an insurer owned by several parents

Advantages of Captive Insurer

• When insurance is expensive or difficult to obtain

• Lower Costs

  • No agent or broker commissions

  • Interest earned on invested premium

• Easier access to reinsurance market

• Possibility of lower tax rate

• 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

• Form of a group captive that can write any type of liability coverage except employers' liability, workers compensation, and personal lines

• Exempt from many state insurance laws

• Many physicians form a risk retention group

Noninsurance Transfer

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

• Ex. Contracts, leases, hold-harmless agreements (if a 3rd party files a suit against the tenant and the landlord, the tenant assumes the risk)

Insurance

• Appropriate for low-frequency, high-severity loss exposures

• These areas must be emphasized

  • Selection of insurance coverages

  • Selection of an insurer

  • Negotiation of terms

  • Dissemination of information concerning insurance coverages

  • Periodic review of the insurance program

Excess Insurance

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

  • Have a general liability (primary) limit & can have an umbrella liability (excess)

Manuscript Policy

A policy specifically tailored for the firm

Technique Graph for What Should be Used

Separation, duplication, and diversification may appear in various quadrants depending upon how they are used

Underwriting Cycles

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

• Soft Market - Profitability is improving, standards are loosened, premiums decline, and insurance become easier to obtain

 Step 4: Implement and Monitor the Chosen Techniques

• Often requires cooperation among multiple departments

• Periodically review to ensure that technique is achieving expected results

• If needed, adjust to accommodate changes in loss exposures or the availability of cost-effective risk management techniques

Benefits of Risk Management

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

• Society benefits because both direct and indirect losses are reduced

• Can reduce a firm's cost of risk

Textbook Definition of Insurance

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

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

• Ex. Consider a coin flip (50/50) - the more you flip it, the closer the percentage gets 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

Payment of Fortuitous Losses

• Fortuitous - unforeseen and unexpected by the insured and occurs a result of chance

  • Hurricane Ex. If you attempt to buy homeowners insurance when a hurricane is approaching, a wind loss is not fortuitous. Insurance company will deny you

  • An intentional act can result in a fortuitous loss

Risk Transfer

A 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

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 average loss based on the Law of Large Numbers

• Large numbers of similar exposure units needed

• Can an insurance company insure things that they don't insure a large number of?

  • Yes, but there will probably be a high premium

Loss Must be Accidental and Unintentional

• Loss should be outside of insured's control

• Why?

  • Law of Large Numbers is based on randomness

  • If the insured can deliberately cause a loss that insurer covers, what is increased? Moral Hazard

Loss Must be Determinable and Measurable

• Determinable

  • Can you determine if a loss occurred?

  • When might this be easy? Hard?

• Measurable

  • Can you determine the amount of the loss?

  • When might this be easy? Hard?

Loss Should Not be Catastrophic (to the Insurer)

• Allows pooling technique to work

• Examples of catastrophes - terrorism, flood, earthquake

• Why is a catastrophic loss problematic?

• Solutions for insurers

  • Reinsurance

  • Diversification

Chance of Loss Must be Calculable

• Must be able to calculate average frequency and average severity

• You multiply them together to calculate expected loss

Premium Must be Economically Feasible

• Insured must be able to afford it

• Life Insurance Ex. The premium would be more economically feasible for a younger person than a 90 year old

Adverse Selection

• Consumers with the greatest possibility of loss, are those that are most likely to purchase insurance

  • 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

• Ex. Selling a car when you know there are some issues with it, but the buyer does not

Credit-Based Insurance Score

• Utilizes a consumer's credit history to predict the likelihood of future insurance losses

• Introduced in the early 1990s

• Not the same as credit score

Credit Score v. Credit-Based Insurance Score

Adverse Selection Pricing Example

AIC is experiencing Adverse Selection

• AIC charged an average rate for all risks

• High risk individuals had an incentive to buy from AIC because the premium was too low relative to their risk

• Because they were high risk, AIC insureds tended to have more accidents and higher claims

• AIC's underwriting results deteriorated (low premium and high losses)

Types of Private Insurance

• Life & Health

• Property & Liability

Life Insurance

Pays death benefits to beneficiaries when the insured dies

Health Insurance

Covers medical expenses because of sickness or injury

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

Refers to insurance that covers whatever is not covered by fire, marine, and life insurance

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 Examples

• Old-Age, Survivors and Disability Insurance (Social Security) - any government system that provides monetary assistance to people with an inadequate or no income

• Unemployment

• Medicare

Found at both federal and state level

• Federal Deposit Insurance Corporation (FDIC) - Insures banks deposit up to $250,000 per depositor

• National Flood Insurance Program (NFIP) - live on coast/ near body of water; provides insurance to help reduce the socio-economic impact of floods

• Fair Access to Insurance Requirements Plans (FAIR) - State-mandated, last-resort insurance programs providing essential property coverage to homeowners and businesses unable to secure insurance through the voluntary market

• Beach and Windstorm Plans - Designed to provide coverage for wind and hail damage in high-risk coastal areas where private insurers refuse to provide it