What is risk?
a calculated possibility of a negative outcome
Calculated Possibility
-probalistic outcome that is known/estimated
-0% impossible event (no risk)
-50% highest risk (most uncertainty)
-100% certain event (no risk)
Negative outcome
loss that must be quantifiable
Frequency
- how often a loss occurs
- the # of losses that occur within a specified time period
-Probability of a loss
EX: probability of a fire is 0.0071 per loss exposure per year
Severity
how much does it cost when a loss does occur?
- the dollar amount of loss for a specific peril
EX: Average fire loss is $32,547
Peril
cause of a loss
EX: fire, tornado, collision, burglary
Hazard
a condition that creates or increases the frequency or severity of loss
- does not cause a loss
Physical Hazard
a physical condition that increases the frequency or severity of loss
Moral Hazard
Arises when people behave recklessly because they know they will be saved by insurance if things go wrong
EX: using a hammer to create "hail" damage to a roof
Morale (Attitudinal) Hazard
carelessness or indifference to a loss because of the existence of insurance
EX: leaving keys in unlocked car
Legal Hazard
characteristics of the legal system or regulatory environment that increase the frequency or severity of losses
EX: juries are more sympathetic in some areas more than others
Risk Classifications
pure vs. speculative risk
diversifiable risk
nondiversifiable risk
enterprise risk
systemic risk
Pure Risk
1. loss
2. no loss
ex. fire, cancer, dog bites
YES: insurance
Speculative Risk
1. loss
2. no loss
3. gain
ex. investment, gambling
NO: insurance
Diversifiable Risk
-affects only individuals or small groups
- can be reduced/eliminated through diversification
- risks arent correlated (fire, theft, collision)
nondiversifiable risk
a risk that affects the entire economy or large numbers of persons or groups within the economy
- cannot be reduced through diversification
-govt assistance may be needed to insure
- risks are correlated (inflation, unemployment)
Enterprise Risk
encompasses all major risks faced by a business firm, which include: pure risk, speculative risk, strategic risk, operational risk, and financial risk
Systeic Risk
-risk of collapse of an entire system or entire market due to the failure of a single entity or group of entities that cna result in the breakdown of the entire financial system
- instability in the financial system due to the interdependency between the
Types of Pure Risks
personal risks, property risks, liability risks, cyber-security, loss of business income
Personal Risk
-directly affect an individual or family
-perils involved
Property Risk
- possibility of losses associated with the destruction or theft of property
- direct loss - cost to repair/replace property damaged by a peril
- indirect loss - financial loss resulting as a consequence of a direct loss
EX: fire damages to your home, pay
liability risk
- legal liability (financial consequences) resulting from injuries or damages you caused
- no upper limit
- liens can be placed on income, assets seized
- defense costs - lawyers are expensive
Loss of business income
- business shut down for period or time, unable to generate income
- indirect loss
Risk Control
techniques to reduce frequency and/or severity of loss
Risk Financing
techniques that provide for the funding of losses
Risk Control: Loss Prevention
- reduce frequency
ex: airport security, safety training programs
Risk Control: Loss Reduction
- reduces severity
-can occur pre-loss or post-loss
ex: duplication, separation & diversification
Risk Control: Avoidance
- a certain loss exposure is never acquired (proactive)
- an existing loss exposure is abandoned (reactive)
Risk Financing: Retention
- retaining part or all of the losses that can occur from a given risk
Active retention
means that an individual is aware of the risk and deliberately plans to retain all or part of it
passive retention
means risks may be unknowingly retained because of ignorance, indifference, or laziness
noninsurance transfers
methods other than insurance by which a pure risk and its potential financial consequences are transferred to another party
- by contract
- incorporation
Definition of Insurance
the pooling of fortuitous losses by transfer of such risks to insurers, who agree to indemnify insureds for such losses, to provide other pecuniary benefits on their occurrence, or to render services connected with the risk
Law of Large Numbers (LLN)
greater the number of exposures, the more closely will actual results approach the probable results expected from an infinite number of exposures
Pooling of losses
the spreading of losses incurred by the few over the entire group, so that in the process, average loss is substituted for actual loss
- purpose is to reduce variations (measured by standard deviation)
fortuitous
accidental
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 his or her approximate financial position prior to the occurrence of the loss
characteristics of an ideally isurable risk
- large # of exposure units
- loss must be accidental & unintentional
- loss must be determinable and measurable
- loss should not be catastrophic
- chance of loss must be calculable
- premium must be economically feasible
Large # of Exposure Units
- enables the insurer to predict average loss based on the LLN
- large # of similar exposure units needed
Loss must be accidental & unintentional
- outside of insured's control
-LLN based on randomness
the loss must be determinable and measurable.
Definite cause, time, place, and amount of loss.
Loss should not be catastrophic to insurer
- allows pooling techniques to work
ex: hurricanes, earthquakes
solutions - diversification
Chance of Loss Must be Calculable
must be able to calculate average frequency and average severity
Adverse Selection
the tendency of persons with a higher-than-average chance of loss to seek insurance at standard rates
- results from asymmetric information
asymmetric information
a situation in which one party to an economic transaction has less information than the other party
credit-based insurance scores
Insurers use an applicant's credit rating for underwriting in auto and homeowners insurance
private insurance
the insured pays a monthly premium for insurance plan
life insurance
Provides payment to beneficiaries who were named by the insured person
health insurance
Provides money to pay for health care for illness, injury, or, in some cases, preventive care
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 hevenly weighted in favor or low-imcome groups
- eligibility/benefits are prescribed ny statue
ex. social security. unemployment, medicare
- found at noth
Risk Management
a 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 occurs
Steps in the Risk Management Process
1. Identify loss exposures
2. Measure and analyze the loss exposures
3. Select the appropriate combination of techniques for treating the loss exposures
4. Implement and monitor the risk management program
Step 1: Identify Loss Exposures (most important step)
-sources
loss history
financial statements
other firms/competitors
risk management consultants
surveys/questionaires
inspections
contract analysis
flowcharts
Step 2: Measure
-estimate the frequeny/severity of loss exposure
- often and costs
Step 2: 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
Avoidance
advantages: frequency is reduced to 0!
disadvantages: may not be possible
usually has an opportunity cost
avoiding one loss exposure may cause another
When should risk be retained?
- it is difficult to insure
- worst possible losss are low severity
- losses are predictable (high frequency)
RETENTION: a captive insurer
an insurer owned by a parent firm for the purpose of insuring the parent firms loss exposures
single parent captive - one
group parent captive - multiple
Advantages of Captive Insurer
- can help a firm when insurance is expensive/ difficult to obtain
-lower costs
- no agent/broker commissions
- easier access to reinsurance market
- possibility of lower tax rate
- possibilty of favorable regulatory environmet
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
A group captive formed under the requirements of the Liability Risk Retention Act of 1986 to insure the parent organizations.
noninsurance transfers
methods other than insurance by which a pure risk and its potential financial consequences are transferred to another party
noninsurance transfers advantages
- can transfer some losses that are not insurable
- less expensive
- can transfer loss to someone who is in a better position to control losses
noninsurance transfers disadvantages
- contract language may be ambiguous so transfers may fail
- if other party fails to pay, firm is still responsible for losses
- insurers may not give credit for transfers
Commercial Insurance
appropriate for low-probability, high-severity loss exposures
Deductible
Specified amount of money that the insured must pay for covered medical expenses before the insurance policy begins to pay; usually annual amount per individual or family
Excess Insurance
a plan in which the insurer does not participate in the loss until the actual loss exceeds the amount a firm has decided to retain
Manuscript Policy
a policy specially tailored for the firm
Commerical Insurance Advtanges
- firm is indemnified for losses; can continue to operate
- uncertainty is reduced
- firm may receive valuable risk management services
- premiums are income-tax deductible
Commerical Insurance Disadvantages
- premiums may be costly
- negotiation of contracts takes time & effort
- the r.m. may become lax in exercising loss control
Underwriting Cycle "hard" market
profitability is declining, underwriting standards are tightened, premiums increase, and insurance is hard to obtain
Underwriting cycle: Soft Market
profitability is improving, standards are loosened, premiums decline and insurance is easier to obtain
Benefits of Risk Management
-Enables firm to attain its pre-loss and post-loss objectives more easily
-A risk management program can reduce a firm's cost of risk
-Reduction in pure loss exposures allows a firm to enact an enterprise risk management program to treat both pure and spe
Cost of Risk
measures costs associated with treating the organization's loss exposures
- insurance premiums paid
- retained losses
- loss control expenditures
- outside r.m. services
- financial guarantees
- internal administratice costs
- taxes, fees & other relevant