Asymmetric information
one party knows more than the other (Split or Steal game)
What is Risk?
Traditionally de?nition
Risk = Uncertainty
What is Risk?
Better de?nition
Uncertainty about chance, timing, or amount of loss
Objective Risk
Example
the relative variation of actual loss from expected loss
N = 10,000 cars
Expect 1% to have a loss (100 losses)
Worst year in the past = 110 losses
Objective Risk = 10/100 = 0.10 or 10%
Higher variation?Higher risk
Law of Large Numbers
Law of Large Numbers
Objective Risk Varies inversely with the square root of the number of cases (e.g., cars)
With N = 10,000,?N = 100
With N = 1,000,000,?N = 1,000
Since the?N is ten times greater now, Objective Risk will be ten times smaller
So, if you run an insurance comp
Subjective Risk (standard deviation)
Uncertainty based on a person's mental condition or state of mind
May differ across time and individuals
Consider:
December 6, 1941
September 10, 2001
Individual with a DUI
65-year-old
Peril
The cause of the loss
Hazard
A condition that increases the frequency or severity of the loss
Physical Hazard
icy roads, etc.
Moral Hazard
(e.g., keys) - a "conscious decision" to behave differently because you have some sort of safety net (having insurance)
FOCUS on "Moral Hazard" rather than "Morale
Morale Hazard
an indifference because you have the safety net
(e.g.) arson
Pure Risk
Chance of loss or no loss --- no chance of gain
Speculative Risk
(Implies there is a "win" possibility)
Chance of loss, no loss, or gain
Particular Risk
A risk that affects only individuals as individuals
Fundamental or Systematic Risk
Risk that affects a large number of individuals or the entire economy
Enterprise Risk
A term that encompasses all major risks faced by a business ?rm
Personal Risks
Risk of Premature Death
Risk of Insuf?cient Income During Retirement
Risk of Poor Health
Risk of Unemployment
Property Risk: Direct Loss
(anything tangible)
Financial loss that results from the physical damage, destruction, or theft of the property
e.g., Phone is broken when dropped
Property Risks: Indirect Loss
(loss of future income, etc.)
Financial loss arising from loss of use of property
e.g., lost business, lost future opportunities
Liability Risks
Responsibility for actions that cause injury or property damage to another
No maximum upper limit
Liens on future wages can be imposed
May result in legal defense costs, regardless of merit of claim
Burden of Risks on Society
Requires Emergency Funds
Outlays to Reduce Risk (preemptive)
Expense of Financing Potential/Actual Losses
Increased Prices/Loss of Certain Goods & Services
Worry and Fear
Time
Losses for Which We Are Not Indemni?ed
Costs of Risks": Outlays to Reduce Risk
(e.g., potential shoplifting)
Video cameras, tags on merchandise, alarm system, locks
Costs of Risks": Opportunity Cost
employee time, management time
Costs of Risks": Expenses from Financing Potential Losses
cost of insurance, cost of setting up a "captive insurer
Costs of Risks": Cost of Losses Not Reimbursed
Value of stolen property, damaged property, higher insurance costs
Financial risk Management
refers to the identi?cation, and treatment of speculative ?nancial risks
-Commodity price risk
-Interest rate risk
-Currency exchange rate risk
Integrated Risk Management Program
a risk treatment technique that combines coverage for pure and speculative risks in the same contract
Chief Risk Of?cer (CRO)
responsible for the treatment of pure and speculative risks faced by the organization
Enterprise Risk Management (ERM)
a comprehensive risk management program that addresses the organization's pure, speculative, strategic, and operational risks
As long as the risks combined are not perfectly and positively correlated, the combination of loss exposures reduces its overall
To what extent have businesses adopted enterprise risk management programs?
Each year, the Risk and Insurance Management Society (RIMS) and the world's largest insurance broker, Marsh, publish the "Excellence in Risk Management" report
Explanations for the failure of ERM at ?nancial organizations
Failure to embrace appropriate ERM behaviors
Failure to develop and reward internal risk management competencies
Failure to use ERM to inform management's decision making for both risk-taking and risk-avoiding decisions
Too much reliance on past events as
Credit Default Swap (CDS)
IMPORTANT: Look up video
An agreement in which the risk of default of a ?nancial instrument is transferred from the owner of the ?nancial instrument to the issuer of the swap
CDS use by AIG was a major cause of their ?nancial distress in 2008
Are CDSs insurance products?
Sellers are not required to maintain reserves
CDSs are not based on the law of large numbers or actuarial analysis
The purchaser of a CDS does not need an insurable interest in the underlying asset
The Underwriting Cycle
"Hard/Soft market"?
the cyclical pattern of underwriting stringency, premium levels, and pro?tability
"Hard Market": tight underwriting standards, high premiums, and unfavorable insurance terms lead to more retention
"Soft Market": loose underwriting standards, low premiums,
Capacity can be affected by...
a clash loss, which occurs when several lines of insurance simultaneously experience large losses
Investment return is another factor that may be used to...
offset underwriting losses, allowing insurers to set lower premium rates
Securitization of risk
means that insurable risk is transferred to the capital markets through creation of a ?nancial instrument
A catastrophe bond
permits the issuer to skip or defer scheduled payments if a catastrophic loss occurs (a "named storm" - CAT Bonds)
The impact of risk securitization is...
an increase in capacity for insurers and reinsurers�it provides access to the capital of many investors
Probability Analysis
Involves not only examining probabilities, but also whether losses are related or not (independence)
Regression Analysis
Characterizes the relation between two or more variables and uses this to predict values of a variable
Loss Distributions
A probability distribution of losses that could occur
Value at risk (VAR) analysis
involves calculating the worst probable loss likely to occur in a given time period under regular market conditions at some level of con?dence
- The VAR is determined using historical data or running a computer simulation
- Often applied to a portfolio of
Catastrophe modeling
a computer-assisted method of estimating losses that could occur as a result of a catastrophic event
Model inputs include seismic data, historical losses, and values exposed to losses (e.g., building characteristics)
Models are used by insurers, brokers,
Consolidations
The number of ?rms has declined due to mergers and acquisitions
Convergence
Existing ?nancial institutions now sell a wide variety of ?nancial products that earlier were outside their core business area
Life and Health Insurers
These insurers sell life and health insurance products, annuities, mutual funds, pension plans, and related ?nancial products
Property and Casualty Insurers
These insurers sell property and casualty insurance and related lines, including marine coverages and surety and ?delity bonds
Sock Insurers
A stock insurer is a corporation owned by stockholders
Objective: Earn pro?t for stockholders
- Increase value of stock
- Pay dividends
Stockholders elect board of directors, who in turn appoint executive of?cers to manage the corporation.
Stockholders be
Mutual Insurers
A mutual insurer is a corporation owned by the policyowners �
- Policyowners elect board of directors, who have effective management control �
- May pay dividends to policyowners, or give a rate reduction in advance �
- In life insurance, a dividend is la
Lloyds of London
Lloyd's of London is not an insurer, but a society of members who underwrite insurance in syndicates
- Membership includes corporations, individual members (Names), and Scottish limited partnerships
- New individual members, or Names, who belong to the va
captive insurer
an insurer owned by a parent ?rm for the purposes of insuring the parent ?rm's loss exposures
Savings Bank Life Insurance
refers to life insurance that is sold by mutual savings banks, over the phone or through web sites
- The objective is to provide low-cost life insurance to consumers by holding down operating costs and the payment of high sales commissions to agents
Agent
someone who legally represents the principal and has the authority to act on the principal's behalf
Authority may be:
- Expressed
- Implied
- Apparent
The Principal
responsible for all acts of an agent when the agent is acting within the scope of authority
property and casualty agent
has the power to bind the insurer
a Binder...
provides temporary insurance until the policy is actually written
A Life Insurance Agent...
normally does not have the authority to bind the insurer
- The applicant for life insurance must be approved by the insurer before the insurance becomes effective
A Broker...
someone who legally represents the insured and...
- solicits applications and attempts to place coverage with an appropriate insurer
- is paid a commission from the insurers where the business is placed
- does not have the authority to bind the insurer
Large brokerage ?rms have knowledge of:
highly specialized insurance markets
provide risk management and loss-control services
handle the accounts of large corporate insurance buyers
Fortuitous
� Random (accidental losses)
� Intentional losses are not paid!
Indemnification
� "to make whole"
� Means that the insured is restored to the condition prior to the loss
Pooling of Losses
� Spreading losses of a few over an entire group (pool)
� Risk reduction based on the Law of Large Numbers
Payment of Fortuitous losses
� Pay for losses that are unexpected, unforeseen, or occur as a result of chance
Risk Transfer
A pure risk is transferred from the insured to the insurer, who typically is in a stronger ?nancial position to pay the loss than the insured
Fortuitous Loss
Loss that is unforeseen and unexpected by the insured and occurs as a result of chance
� The law of large numbers is based on the assumption that losses are accidental
� Cannot be an intentional loss
Ideally Insurable Risk
Large number of homogenous exposure units
Accidental and unintentional loss
Determinable and measurable loss
No catastrophic loss
Calculable chance of loss
Economically feasible premium
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
- Results in higher losses and expenses than expected
- P
Underwriting
� Involves selecting and classifying insurance applicants
� Has certain standards that must be met for standard/preferred rates
� If standards are not met, higher rates apply
Policy Provisions
� e.g., Suicide clause in life insurance
� e.g., Insurance contracts typically not assignable
Insurance vs. Gambling
� Gambling creates risk, insurance handles existing risk
� Gambling is zero-sum, insurance is win-win
Insurance vs. Hedging
� Insurance uses law of large numbers to reduce risk
� Hedging transfers risk (e.g., to speculators who willingly take on the risk)
Private Insurance (4 of them listed)
Life Insurance
Health Insurance
Property Insurance
Liability Insurance
Social Insurance (3 examples)
� OASDI
� Medicare
� Unemployment Insurance
Other Insurance
� FDIC
� Flood Insurance
4 Social Benefits of Insurance
Indemni?cation for loss
Reduction of worry and fear
Source of investment funds
Loss prevention
3 Socials Costs of Insurance
Cost of Claims
Increased Moral Hazard
Cost of Insurance Mechanism�"Expense Load
Risk Management Process (4 Steps)
hint: I.E.S.I.
1) Identify potential losses
2) Evaluate potential losses
3) Select the appropriate risk management techniques
4) Implement and monitor the risk management program
loss Frequency
� Car accidents happen every in the U.S.?
� Not high frequency for individual drivers
Loss Severity
� Maximum Possible Loss
� Maximum Probable Loss
Retention:
- Definition
- Most effective when (3 things)
Firm retains part or all of the losses that can result from a given loss
- No other method is available
- The worst possible loss is not serious
- Losses are fairly predictable
Current Net Income
Losses treated as current expenses
Unfunded Reserve
Losses are deducted from a bookkeeping account
Funded Reserve
Set aside liquid funds
a Captive Insurer...
an insurer owned by a parent ?rm for the purpose of insuring the parent ?rm's loss exposure
Many captives are located in the Caribbean because of...
the favorable regulatory environmet, relatively low capital requirements, and low taxes
Captives are formed for a number of reasons (5 here)
� Parent may have dif?culty obtaining insurance
� Favorable regulatory environment
� Costs may be lower than purchasing commercial insurance
� A captive insurer has easier access to a reinsurer
� A captive insurer can become a source of pro?t
A Risk Retention Group is...
a group captive that can write any type of liability coverage except employer liability, workers compensation, and personal lines
� Federal regulation allows employers, trade groups, governmental units, and other parties to form risk retention groups
� Th
Retention Advantages (4)
save on loss costs (long run)
save on expenses
encourage loss prevention
increase cash flow
Retention Disadvatages
possible higher losses (short run)
possible higher expenses
possible higher taxes
Insurance is appropriate for loss exposures that have...
a low probability of loss, but for which the severity of the loss is high
An excess insurance policy is...
one in which the insurer does not participate in the loss until the actual loss exceeds the amount a ?rm has decided to retain
The risk manager negotiates the terms of the insurance contract:
� A manuscript policy is a policy specially tailored to the ?rm
� The parties must agree on the contract provisions
� If the ?rm is large, the premiums may be negotiable
Insurance Avantages (4)
Firm is indemni?ed for losses
Uncertainty is reduced
Insurers may provide other risk management services
Premiums are tax-deductible
Insurance Disadvatages (3)
Premiums may be costly: consider opportunity cost
Negotiationofcontractstakes time and effort
The risk manager may become lax in exercising cost control
A non-insurance transfer is...
- examples?
a method other than insurance by which a pure risk and its potential ?nancial consequences are transferred to another party
Examples include: contracts, leases, hold-harmless agreements
Non-Insurance Transfers Advantages (3)
Cantransfersomelossesthat are not insurable
Cost less than insurance
Can transfer loss to someone who is in a better position to control losses
Non-Insurance Transfers Disadvantages (3)
Contract language may be ambiguous, so transfer may fail
If the other party fails to pay, ?rm is still responsible for the losses
Insurers may not give credit for transfers, and the insurancecostsmaynotalwaysbe reduced
A risk management manual may be used to: (3 things)
� Describe the risk management program
� Train new employees
� State risk manager's responsibilities, objectives, available techniques, and responsibilities of other parties
The risk management program should be...
periodically reviewed and evaluated to determine whether the objectives are being attained
Reduction in pure loss exposures allows a ?rm to:
enact an enterprise risk management program to treat both pure and speculative loss exposures.