RISK MANAGEMENT AND INSURANCE TOPIC 1 FUNDAMENTALS AND

RISK MANAGEMENT AND INSURANCE TOPIC 1 FUNDAMENTALS AND TERMINOLOGY

RISK • Risk: is the possibility of bearing unwanted events. • Risk is defined as uncertainty of loss. • Uncertainty: The perception that several different outcomes are possible. 2

Definition of Risk • There is no single definition of Risk; however, two distinctive definitions are used commonly. • The variations in possible outcomes of an event based on chance. (greater the number of different outcomes that may occur, the greater the risk). • “Risk is an uncertainty concerning a possible loss”. 3

Who Are Under Risk? • Individuals, • Companies, • Organizations • Governments, etc. face with loss from natural disasters. 4

Risk Taking Behavior • Risk-Averse • Risk-Neutral • Risk-Taker (Risk-Seeker, Risk-Lover) 5

Risk and Relative Return Zone 1 Insufficient Risk Taking Zone 2 Optimal Risk Taking Risk. Adjusted Return Risk Zone 3 Excessive Risk Taking

What are the Sources of Risk? • • Physical Environment Social Environment Political Environment Legal Environment Operational Environment Economic Environment Cognitive Environment 7

Categorizing Risk • Pure Risk : is the situation that can result in only loss or no change. Example: premature death, damage to a property from fire, lightening, flood, etc. • Speculative Risk: refers to those exposures that can result in loss, gain or no change. Example : If you purchase 100 shares of common stock if the price goes up you make a benefit but the price goes down you make a loss. 8

The Degree of Risk • The Degree of Risk: is a measure of the accuracy with which the outcome of an event based on chance can be predicted. (Health certificate, occupations) Ø Insurers use risk to identify the property or life that is being insured. Ø “Loss exposure” is used instead of risk in the insurance industry 9

Examples of Risks • Risk of being killed in the auto accident. • Risk of lung cancer for smokers. • Risk of failing in examination or college course. Examples of presence of risks in our society: • A gunman kills 10 customers in a local department store • A small town is wiped out by tornado. • A drunk driver kills 5 people in a van on a expressway. 10

RISK MANAGEMENT • Risk Management: The art and science of anticipating these potential losses and developing a plan to survive them. Hurricane Katrina: Landfall August 29, 2005 11

Why Manage Risk? - Individuals • Reduce anxiety • Planning 6

Why Manage Risks - Corporation (Nexus of Contracts) 13

INSURANCE • Insurance protects you against potential financial losses or liability as a result of unexpected events. • Its primary function is to maintain your existing level of wealth. • Insurance is beneficial even when no payments are received from the insurance company. 14

The Two Definitions of Insurance • Financial Definition of Insurance: Insurance is a financial arrangement that redistributes the costs of unexpected losses. • Legal Definition of Insurance is a contractual arrangement whereby one party agrees to compensate another party for losses. 15

Some Insurance Terms (Actors of the Game) • Insurer : Party agreeing to pay for the losses. • Insured: Party who loss causes the insurer to make a claims payment. • Premium: is the payment insurer receives. • Policy: is the insurance contract • Exposure to Loss: the insured’s possibility of loss. (The exposure is transferred to the insurer by purchasing an insurance policy) 16

Some More Insurance Terms • Sum Insured: a maximum amount that an insurance company will pay to someone who makes a claim. • Claim/Loss: formal request to an insurance company asking for a payment based on the terms of the insurance policy. • Reinsurance: Practice where an insurance company (the insurer) transfers a portion of its risks to another (the reinsurer). Known as insurance for insurers. • Solvency Ratio: Available capital / Required capital. • Laws and Regulations: Governs and regulates the insurance industry and those engaged in the business of insurance. • The Superintendent (Regulator): is the competent authority of the insurance sector. Exercise all the powers granted by law for the purpose of protecting the policyholders and the insurance beneficiaries. 17

Insurance System • It redistrubutes the cost of losses by collecting a premium payment from every participant (insured) in the system • Insurer promises to pay the insured’s claims in the event of covered loss. • Only a small percentage of insured suffers losses. • Insurance reduce risk through pooling and operation of law of large numbers. 18

Basic Characteristics of Insurance • Pooling of Losses Ø Spreading losses incurred by the few over the entire group. Ø Risk reduction based on the ‘law of large numbers’ • Payment of fortuitous losses Ø Insurance pays for the losses that are unforeseen, unexpected and occur as a result of chance. • Risk transfer Ø A pure risk is transferred from the insured to the insurer, who typically is in a stronger finanicial position. • Indemnification Ø The insured is restored to his or her approximate financial position prior to the occurence of the loss 19

The Costs and Benefits Insurance System Cost Of Insurance • • • Operating Expense Distribution cost Underwriting cost Policy administration cost Reserve cost Moral hazard resulting in extra cost • Exaggerated Losses • Benefit-cost tradeoff • Reinsurance cost 20

Benefits of Insurance to Individuals • Peace of mind • Aversion of risk • Protects mortgaged properties • Provides self dependacy • Tool of savings • Tool of Investment • Satisfies various needs 21

Benefits of Insurance contn’d. . Benefits of Insurance to Business • • • Reduced reserve requirements Capital freed for invesment Indemnification Reduction of uncertainity Reduced cost of capital Reduced credit risk Risk assesment / Risk management Loss contro activities Business and social stability 22

Benefits of Insurance contn’d. . Benefits of Insurance to Society • Protects and contributes wealth of the country (loss prevention, medical research) • Helps in economic growth (insurances collect savings and re-invest into the economy) • Controls inflation • Social peace • Stability in families • Anti-monopoly device. (Only large corporations would be able to stay in business as small would not be able to sustain losses and remain in operation) 23

LOSS Loss: being without something previously owned. Insurable Loss: an undesired, unplanned reduction of economic value arising from chance. (Depreciation and other expenses are exluded) Direct Losses: • Immediate, first result of an insured peril • Property Insurance, Car Insurance Indirect Losses: • Consequential losses • Secondary result of an insured peril 24

Chance of Loss • It refers to a fraction; Ø Chance of Loss: Actual or expected number of losses Number of exposures to loss Ø A priori chance of loss: expected no. of loss exposure units Ø An ex-post (actual) chance: actual no. of losses total no. of exposure units 25

Terms Related to Loss • Peril : is the cause of loss. • Hazards : are the conditions that increase either the frequency or the severity of losses. • Moral Hazard : If a person does a harm on a property to have the money for the loss, the loss is said to result from the moral hazard (dishonesty). • Morale Hazard : refers to an attitude of indifference or carelessness to loss created by the purchase of an insurance contract. “Why should I care? , I am insured” • Proximate Cause: The first peril in a chain of events leading to a loss. The cause without which the loss would not have occurred. It is the most important concept in insurance (Hurricane Katrina, 2005). 26

THE MATHEMATICAL BASIS FOR INSURANCE • Losses needs to be predicted accurately. • Law of Large Numbers: The greater the number of observations of an event based on chance, the more likely the actual results will approximate the expected results. • This system allows an insurance to reduce risk. • Based on law of large numbers, if there are large number of similar but not necessarily identical exposure units, the insurer may be able to predict future losses with greater accuracy. 27

Practical Example of the Law of Large Number You flip a balanced coin into the air, the probability of getting head(actual probability) is 0. 5. If you flip the coin 10 times, you may get a head eight times and then the observed probability of getting a head is 0. 8. If you flipped 1 million times, however, the actual number of heads would be approximately 500, 000. Thus, if the number of random tosses increases, the actual results approach the expected results. 28

UNDERWRITING • Underwriting : The process of pricing the insurance and selecting the insured is called underwriting. 29

Cash Flow Underwriting • Cash Flow Underwriting: describes the practice of trying to attract new business by pricing insurance “at a loss”. • Loss ratio: Percentage of the earned premium represented by losses. incurred losses/ earned premiums • Expense ratio: Total Expenses/ written premiums Unearned premiums: written premiums-earned premiums • Combined Ratio: sum of the losses and the expense ratio. • At some cases even with combined ratios above 100 %, the insurance industries may be making profit because investment earnings exceeded underwritting losses. Insurance industry making loss in insurance underwritting but offsetting them by investment income. 30

Arson: Who Really Pays for Insured Losses? • Arson: Deliberate, malicious burning of a building or other property t collect insurance proceeds. (eg: unprofitable businesses such as restaurants and hotels) • Selling and reselling the same property between conspirators, each sale at higher price with the final highly inflated ‘market’ value being insured. • Overall, it is the honest premium-paying insured, not the insurer, who pays for the losses. 31