RISK MANAGEMENT AND INSURANCE TOPIC 2 INSURABLE LOSS

RISK MANAGEMENT AND INSURANCE TOPIC 2 INSURABLE LOSS EXPOSURES

CHARACTERISTICS OF AN IDEALLY INSURABLE RISK • Private insurers only insure pure risk but not all pure risks are insurable. A pure risk ideally should have certain characteristics to be insurable. 1. 2. 3. 4. 5. Large number of exposure units. Loss must be accidental and unintentional. Loss must be determinable and measurable. Chance of loss must be calculable. Premium must be economically feasible. 2

1. Large Number of Exposure Units • There should be a large number of similar but not necessarily identical exposure units that are subjected to the same peril or group of perils. Ø Example: Large number of houses in a city can be insured through property insurance on houses. • Accurate prediction of losses based on the law of large numbers is the purpose of first requirement. (To predict average loss) 3

2. Accidental and Unintentional Loss • The loss should be unseen and unexpected by the insured and outside the insured’s control. • If the cause of loss is intentional, the insurer dose not pay for the loss. (e. g: suicide). 4

Accidental and Unintentional Loss contn’d. . . Ø Two reasons why the second requirement is necessary: If the intentional loss was paid by insurer, moral hazard would be increased substantially and the premiums would rise consequently. ( fake accident, fraudulent claim, inflating the amount of a claim, Intentionally burning the unsold merchandise). (To control moral hazard) 1. The loss should be accidental because the law of large numbers is based on the random occurrence of events whereby the intentional loss is not a random event. Therefore, the aim of law of large number is violated due to the prediction of future experience may be highly inaccurate. (To assure randomness) 5

3. Determinable and Measurable Loss • The loss should be both determinable and measurable meaning that time, place and amount of loss should be distinguishable. Ø Example: In life insurance policies usually the time and cause of death can be determinable and the death benefit is usually the face amount of life insurance policy. 6

Determinable and Measurable Loss contn’d. . . • The basic purpose of the third requirement is to enable an insurer to determine if the loss is covered under the policy, and if it is covered, how much should be paid. (To facilitate loss adjustment) Ø Example: Shanon had an expensive fur coat that is insured under homeowners policy. It makes a great deal of difference to insurer if a thief breaks into her home and steals the coat, or the coat is missing because her husband gave it for dry-cleaning and forgot to tell her. The loss is covered in the first example but not in the second. 7

4. Chance of Loss Must be Calculable – No Catastrophic Loss • The loss should not be catastrophic, meaning that a large number of exposure units should not incur losses at the same time. • Pooling techniques does not work if most or all of the exposure units in a certain class simultaneously incur a loss( losses of the few are no longer spread over the entire group). (To allow pooling technique to work) 8

CATASTROPHIC LOSS • A potential loss that is unpredictable and capable of producing an extraordinary large amount of damage relative to the assets held in the insurance pool is called Catastrophic loss exposure. • If catastrophic loss occur a large percent of the loss exposure units in the insurance pool may affect by the losses( losses are not independent). • Catastrophic losses periodically result from floods, hurricanes, tornadoes, earthquakes, forest fires, and other natural disasters or acts of terrorism. • Tornados are not ctastrophic in USA, since they occur regularly and are predictable with a reasonable accuracy. • Earthquakes and volcanic eruptions do not occur regularly. 9

Some Views from Flood 2012 Lefkoşa 10

Catastrophic Loss contn’d. . . Ø Characteristics of Catastrophic Losses • Limited in geographical area • Not accurately predictable 11

5. Premium Must Be Economically Feasible • Premium must be economically feasible so that people can afford to buy. • By use of law of large numbers, the pool is able to predict losses accurately and charge a premium appropriate to the risk. 12

Premium must be economically feasible contn’d. . . • Attitude toward risk is to pay relatively small premium to uncertain losses. (High premiums will make people prefer to quit having insurance) • In case of highly costly losses government either guarantees or subsidizes to insurers against excessive losses to keep premiums attractive and prevent the exodus of the better situated risk. 13

INSURABLE LOSS EXPOSURES • Which losses are insurable? Ø Gambling losses: • Gambling and Insurance are opposites. • There is no chance like either you win and get the money or lose and get paid by the insurance. • Insurances reduce risk through pooling and operation of law of large numbers. For gmabling, pooling is not possiple. Law of large numbers does not hold. Ø Stock market losses: • Speculative losses can not be insured as this would make the owners in a position of being indifferent to operating results. 14

Which losses are insurable? contn’d. . • Coverage for losses due to pollution is unavailable. • Limited amounts of Insurance against floods, earthquakes, draughts can be purchased. • Private insurance companies do not offer coverage for unemployment • The private insurance companies must develop coverage constrained by the standards of ideally insurable exposures. 15

What is a Risk Pool or Pooling in Insurance? • A separate account established to hold income and expences. and is used when insurance groups come together to combine their premiums and paying out losses. Typically used during disasters like floods, and other disasters. • Insurance companies reduce risk through pooling and operation of law of large numbers. By the use of law of large numbers, the pool, is able to predict losses accurately and charge a premium appropriate to the risk. 16

Legal Interest • The insurances are prepared and sold to those that have legal interest. • Legal Interest: A term that describe a right, an advantage, a profit, share or revenue. • The insureds should not be indifferent to losses. (This may cause rises in the premiums as a result of losses rising) 17

Insurable Interest • Insured events should represent a loss to them personally. This doctrine is known as insurable interest. • Insurable Interest: A person is regarded as having an insurable interest in something when the loss or damage to the item concerned (insured item) would cause that person to SUFFER a financial and/or other kinds of loss. (e. g. For life insurance, emotional loss if the insured dies. Car owner suffers if the car is stolen) • If the insured does have an insurable interest in the insured item, he or she will not be able to enforce a claim under the insurance policy. 18

IDEALLY INSURABLE LOSS EXPOSURES 1. A large group of similar items exposed to the same peril • An insurance pool needs to have substantial number of individual units to obtain predictive accuracy. (statistical benefit of law of large numbers) • The items in the insurance pool, or the exposure units, need to be similar to enable a fair premium calculation. (Barns of farmers, brick homes and wooden homes) • The perils faced by the exposures in the insurance pool should be the identical perils for the same reasons requiring the exposure to be similar to one another. ( house by a gas station faces additional peril for fire) 19

Ideally insurable loss exposures contn’d. . 2. Losses Must Be Accidental or Beyond the Insured’s Control: • Non-accidential or expected, reductions of economic value such as depreciation or wear and tear are not insurable. • An insurance system will not pay for an insured’s deliberately caused losses. 3. Definite Losses Capable of Causing Economic Hardship. • Losses must be definate: member’s loss must be verifiable (insurance for fire not for mental illness) • Losses must be measurable: losses insured against should be measurable: - the loss of a loved pet, - loss of race horses or valuable livestock represent an insurable exposure as damaged sustained can be measured in economic terms. • Severity: Potential damage should cause economic hardship. For inexpensive items, insurance are not preferred to be purchased. Insurance can be purchased only when losses are large and uncertain. “Large-Loss Principle” 20

Ideally insurable loss exposures contn’d. . 4. Extremely low probability of a catastrophic loss to the insurance pool. • A loss extraordinary large relative to the amounts of property in an insurance pool. If it was insured, it will cause the insolvency of even well-run insurers. • Catastrophic losses from natural disasters have two general characteristics: 1. Limited in geographic impact: 2. Not accurately predictable. Tornados occur regularly ( in USA), predictable with a reasonable accuracy. Earthquakes and volcanic eruptions do not occur regularly. 21

5. When Only the People Most Exposed to Loss Want Coverage • By use of law of large numbers, the pool is able to predict losses accurately and charge a premium appropriate to the risk. • Attitude toward risk is to pay relatively small premium to uncertain losses. (High premiums will make people prefer to quit having insurance) • In case of highly costly losses government either guarantees or subsidizes to insurers against excessive losses to keep premiums attractive and prevent the exodus of the better situated risk 22

Why are some Perils Unisurable? • Against Public Policy • Under the Control of the Insured – Ex. Suicide • Probability of Loss is Too High • Simultaneous Destruction 23

Generally Uninsurable Perils • War, Terrorism, Rebellion, and Insurrection • Intentional Losses • Fading, Rust, Dry Rot, Settling • Production, Marketing, and Political Risks 24

RISK CLASSIFICATION • Each class of insureds should bear a mathematically fair share of the insurance pool’s losses and expenses for an event to be insurable in the private market. Ø Mathematically fair share of losses and expense = (the probability of loss for a given class of loss exposure × average expected dollar loss) Ø Probability of loss: the chance that an event will occur. 25

The Purpose of Risk Classification • Finding the expected probability of loss for the risk class in which the exposure is placed. • Applicants for insurance have been put in classes according to the probability of loss. • Insurers use risk classification to minimize subsidization and adverse selection. (age/gender/place of residency) Ø Risk Class: • Automobile Insurance: Urban, Male, under 24 and no accidents on his driving record. • Life Insurance: Female, 45 yrs old, average height and weight. • Pools should be formed by the insureds that carry same /similar characteristics. (Prob of Loss X $ value exposed to loss) + expenses 26

Risk calssification contn’d. . Subsidization: Ø occurs if each insured does not pay the mathematically fare price for insurance. • if the insured is paying more than the mathematically fair price, the insured provides the subsidy. • If the insured is paying less than the fair price, the insured receives a subsidy. (ex: life and automobile ins) Adverse Selection: Ø occurs when one party to a transaction has more relevant information than another party to the transaction, the party with the superior information can take advantage of the situation. e. g. Purchasing a fire insurance after being threatened by an arsonist. 27

Principles of Risk Calssification Ø Rate Classification Factors on four points: • Separation and Class Homogeneity Male, 20 should be in a different pool from a male, 40. • Reliability information about the factor should be easily obtained and should not be subject to manipulation by the insured, otherwise independent verification from applicants such as health certificate, etc. • Incentive Value Reward good insureds (lower premium for those with below-average loss potential). • Social Acceptability Ø Most difficult underwriting criterion to handle! Ø Definition of “social acceptability” Ø What do we do when mathematically fair insurance exchange conflicts with a socially desired outcome? 28

IMPORTANT SOCIAL ISSUES Ø Debate on the case of AIDS • The cost of aids is very high. Subsidization issue inevitably occurs. It can be the cause of collapse of insurance systems but there arguments. • Accepting the claims due to AIDS, subsidizing some insured and spread the cost of AIDS throughout the country. • The unfairness of the propose underwriting results. High price for society to pay to solve this problem. 29

Important social issues contn’d. . . Ø Automobile Insurance • More accidents occur in the urban areas than in the rural areas. • Medical and repair and medical costs are also higher in the city. • City residents transfer more exposure to loss to the insurance pool. • Young males are responsible for more accident as well as unmarried drivers compared to married ones. • Thus, insurance premiums for young, unmarried, inner city, male drivers are more expensive. • The basis of conflict between the goals of separation and homogeneity, social acceptability and the incentive value. (Penalizing ppl. falling into that particular group although driving carefully. High premiums also discourage people to get insurance which is hardly socially acceptable 30

Important social issues contn’d. . . Ø Pension Benefits • The issue of whether and Individual’s gender is a legal risk classification. • Women live longer than men (as a group), counterargument is that only 15% of them. So is it fair to penalize all women for the longevity of this minority of women? • If men and women each receive identical monthly pension checks based on equal pension contributions. The group of women will receive more money than the man. How about if man and the woman dies on the same month receiving same # of pensions after retirement? Man will have received more pension benefits than woman, if the benefits were based on gender. 31

BRANCHES OF INSURANCE Ø Various categories where insurance transactions traditionally have been made are: GOVERNMENT SOCIAL SECURITY UNEMPLOYMENT 32

PRIVATE LIFE NON-LIFE Life Fire Annuity Marine Medical Expenses and Disability Bonding Causality Automobile Liability Crime Worker’s Compensation 33

Barnches of insurance contn’d. . • Fire Insurance: Generally covers stationary property. Perils as windstorm, riot and vandalism • Business Income: Indirect losses related with fire and other perils • Marine Insurance: Covers Mobile property, ocean marine covers ships and their cargos. • Inland Marine Ins: Covers property moving on planes, trains and trucks. • Bonding: A special type where one party (surety) guarantees the performance (surety bond) or the honesty (fidelity bond) of a second party to a third party. If second party is poor and dishonest than loss to the third party must be paid by the surety. • Life Insurance: It is based on the human life contingencies. If the covered peril is death, the contract is called life insurance. If the peril is survival, the contract is called annuity. The annuity guaranties that the insured will not have to survive without money. If the covered peril is sickness or disability, the coverage is called medical expense insurance or disability insurance. 34

New Coverages • Weather-related insurance: Payments for crop-hail damage, rained -out concerts, or too much or too little snow. • Change-of-law Insurance: Payments are made if new regulations increase construction costs after contracts are signed. • Municipal Bond Insurance: This coverage guarantees principle and interest payments on municipal securities. • Motion Picture Completion Bonds: Payment made if the film is not completed on time. Death of a star or other unforeseen events cause the insurer to pay. • Boiler and Machinery Insurance: Property Ins contracts specifically exclude damage caused by exploding steam boilers. Some insurance companies sell this type of coverage. The insured in addition to the indemnity agreement, have to pay for the regular inspection. 35