Full Exam 1 RMI3011 Content

securitization

Risk

Uncertainty concerning whether a loss will occur.

Knightian uncertainty

Uncertainty in which probabilities cannot reasonably be estimated.

Loss exposure

Any situation in which a loss is possible, whether or not one actually occurs.

Objective risk

The relative variation of actual losses from expected losses; statistically measurable.

Subjective risk

Uncertainty based on a person’s feelings or state of mind.

Capital Markets as alternative

securitization of risk: insurable risk transferred to capital markets thru creation of fin instrument

• use weather derivatives to manage exposure to droughts + freezes affecting agricultural clients

• catastropher bond: corporate bonds that permit issuer of bond to skip/reduce interest payments if catastophic loss occurs - standard supplement

most expensive natural disaster in US

Hurricane Katrina (201.3 billion dollars)

Chance of loss

The probability that an event causing a loss will occur.

Objective probability

The long-run frequency of an event based on many observations under stable conditions.

Subjective probability

A person’s individual estimate of the likelihood of a loss.

Peril

The direct cause of a loss, such as fire, lightning, or collision.

Hazard

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

Physical hazard

A physical condition that increases loss, such as faulty wiring.

Moral hazard

Dishonesty that increases the frequency or severity of loss, such as insurance fraud.

Morale hazard

Carelessness or indifference that increases loss, such as leaving a car unlocked because it is insured.

Legal hazard

Features of the legal or regulatory environment that increase loss frequency or severity.

Independent agencies

• major distribution form for property + casualty insurance

agents are paid a commission based on business produced

• agency may bill the policyholders + collect premiums, but most insurers use direct billing

Pure risk

A situation involving only loss or no loss; no opportunity for profit.

Speculative risk

A situation involving the possibility of profit or loss.

Diversifiable risk

Risk affecting individuals or small groups that can be reduced by spreading exposures.

Nondiversifiable or fundamental risk

Risk affecting large groups or the overall economy that is difficult to reduce through diversification.

Enterprise risk

All major risks faced by a business, including pure, speculative, strategic, operational, and financial risks.

Strategic risk

Uncertainty concerning a firm’s goals, objectives, and business strategy.

Operational risk

Risk arising from a firm’s business operations.

Financial risk

Risk of loss from adverse changes in interest rates, commodity prices, exchange rates, or the value of money.

Systemic risk

The possibility that one entity’s failure triggers a breakdown of an entire financial market or system.

Surplus share treaty

reinsurer agrees to accept insurance in excess of the ceding insurer’s retention limit, up to some maximum amount

• reinsurer’s share of losses and premiums is proportional

Excess of Loss Treaty

designed to protect against catastrophic loss

• can be written to cover single exposure, occurence, or total excess losses

Personal risks

Risks that cause individuals or families to lose income, incur extra expenses, or deplete assets.

Property risks

The possibility of damage, destruction, or theft of property.

Direct loss

Physical damage to or loss of property, such as fire damage to a house.

Indirect or consequential loss

A financial consequence of a direct loss, such as additional living expenses after a house fire.

Liability risk

The possibility of being held legally responsible for injury or damage to others.

Risk control

Techniques that reduce the frequency or severity of losses.

Avoidance

Never taking on an exposure or abandoning it, eliminating that particular exposure to loss.

Loss prevention

Reducing how often losses occur; targets frequency.

Loss reduction

Reducing how severe losses are when they occur; targets severity.

Automatic sprinklers

An example of loss reduction because they reduce fire damage after a fire starts.

Claims Settlement Process

1. notice of loss, asap after loss has occurred

2. next, claim is investigated: adjustor must determine that a covered loss has occurred + determine amount of the loss

3. adjust may require a proof of loss before claim is paid

4. adjustor decides if claim is paid/denied (policy provisions address how disputes r resolved)

Duplication

Maintaining backups or copies so a loss does not eliminate everything needed to operate.

Separation

Placing assets in different locations so one event cannot damage all of them.

Diversification

Spreading exposures among different assets, parties, or activities to reduce overall risk.

Risk financing

Techniques that provide money to pay for losses.

Marketing Systems

refers to various methods for selling + marketing insurance products

• majority of life insurance policies + annuities sold today are through personal selling distribution systems

  • commissioned agent solicit + sell life insurance

  • career agents represent one insurer, paid on commission basis

Retention

Keeping part or all of the financial consequences of a loss exposure.

Active retention

Knowingly and deliberately keeping a risk, such as choosing a deductible.

Passive retention

Unintentionally keeping a risk because it was overlooked or no action was taken.

Self-insurance or self-funding

Planned retention in which a firm directly pays part or all of its own losses.

Noninsurance transfer

Transferring risk to another party without buying insurance, such as through a contract or hold-harmless agreement.

Insurance

Pooling accidental losses and transferring risk to an insurer that provides payment or benefits for covered losses.

Pooling of losses

Spreading the losses of relatively few insureds across the entire insured group.

Fortuitous loss

A loss that is unforeseen, unexpected, and occurs by chance.

Risk transfer

Shifting the financial consequences of pure risk from the insured to an insurer.

Indemnification

Restoring the insured approximately to the financial position held before a loss.

Four basic characteristics of insurance

Pooling of losses; payment of fortuitous losses; risk transfer; indemnification.

Law of large numbers

As the number of similar independent exposures increases, actual losses tend to approach expected losses.

Effect of pooling

Reduces uncertainty about average losses; does not eliminate the expected amount of loss.

Six requirements of an ideally insurable risk

Many exposure units; accidental loss; measurable loss; no catastrophic loss; calculable chance of loss; economically feasible premium.

Large number of exposure units

Enough similar exposures to make average losses predictable through the law of large numbers.

Accidental and unintentional loss

A loss caused by chance rather than deliberately by the insured.

Determinable and measurable loss

A loss whose occurrence and financial amount can be established.

No catastrophic loss

Ideally, one event should not cause losses to a huge portion of the insured pool at once.

Managing catastrophic loss exposure

Use reinsurance, geographic dispersion, and catastrophe bonds to spread catastrophe risk.

Calculable chance of loss

The insurer can estimate loss frequency and severity to set premiums.

Economically feasible premium

A premium that is affordable and substantially less than the potential policy benefit.

Adverse selection

People with higher-than-average chances of loss disproportionately seek insurance at standard rates.

Controlling adverse selection

Use underwriting and policy provisions to select and classify risks appropriately.

Insurance versus gambling

Insurance addresses an existing pure risk; gambling creates a new speculative risk.

Hedging

Using a contract or financial position to offset financial or price risk.

Life insurance

Insurance that pays a stated death benefit when the insured dies.

• long-term, losses are more predictable

independent property + casualty agents

independent contractors who represent several insurers and sell primarily property and casualty insurance

personal-producing general agent (P P G A)

independent agent who places substantial amounts of business with one insurer and has a special financial arrangement with that insurer

Health insurance

Insurance covering medical expenses from illness or injury.

Property insurance

Insurance covering loss of or damage to real or personal property

• contracts are short term

Liability insurance

Insurance covering legal liability for covered injuries or damage to others.

Personal lines

Insurance for individuals and families.

Commercial lines

Insurance for businesses and other organizations.

Social insurance

Government-created programs with eligibility and benefits set by law, financed largely through employer or employee contributions.

Benefits of insurance

Financial recovery; less worry; investment funds; loss prevention; improved access to credit.

Costs of insurance

Operating expenses, fraudulent claims, and inflated claims that increase premiums.

Expense loading

The portion of the premium for expenses, taxes, commissions, contingencies, and profit.

Risk management

Identifying loss exposures and selecting appropriate ways to treat them.

Pre-loss objectives

Prepare economically for losses, reduce anxiety, and meet legal obligations.

Post-loss objectives

Survive, continue operating, stabilize earnings, maintain growth, and minimize effects on others.

Four steps in risk management

Identify exposures; measure and analyze them; select treatment techniques; implement and monitor the program.

Loss frequency

The probable number of losses during a period.

Loss severity

The probable size or financial amount of losses.

Maximum possible loss

The worst loss that could conceivably occur.

Probable maximum loss

The worst loss that is likely to occur.

Why severity often matters more than frequency

One extremely large loss can threaten survival even if losses are rare.

Retention level

The dollar amount of loss a firm intends to keep.

When retention is appropriate

Losses are predictable and manageable, or insurance and other transfers are unavailable.

Financing retained losses

Use current income, an unfunded reserve, a funded reserve, or a line of credit.

Advantages of retention

Potential cost savings, improved cash flow, and stronger incentives to control losses.

Disadvantages of retention

Unexpectedly large losses, administrative costs, and possible adverse tax consequences.

Captive insurer

An insurance company created primarily to insure the risks of its parent or owners.

Single-parent captive

A captive insurer owned by and serving one parent company.

Group captive

A captive insurer owned by and serving multiple organizations.

Risk retention group

A group captive providing liability insurance to members with similar liability exposures.

Stop-loss insurance

Insurance that pays covered losses above a specified retained amount, limiting self-funded losses.