Class 2 Insurance and Risk Management

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Class 2Insurance and RiskManagement

• George D. Krempley
• Bus. Fin. 640
• Autumn Quarter 2007

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Bus. Fin. 640 Website

• http//fisher.osu.edu/fin/autumn2007/640.htm

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Methods of Handling Risk

• Avoidance
• Loss control
• Retention
• Non-insurance transfers
• Insurance

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Risk Management Matrix
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Frequency

• Frequency measures the number of losses in a
  given period over the number of exposures to
  loss.
• If Sharon Steel Corp. had 10,000 employees in
  each of the last five years
• And, there were 1,500 injuries over the 5-year
  period
• Then, the loss frequency would be 0.03
  1500/50,000 employee-years.

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Severity

• Severity measures the magnitude of loss per
  occurrence.
• If the 1,500 injuries cost a total of 3,000,000
• Then, the expected severity of loss would be
  2,000.

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Expected Loss

• The Expected Loss is simply the product of the
  frequency and the severity
• Expected loss Frequency x Severity
• In our example, the Expected Loss equals 60
• 0.03 x 2,000 60
• Also known as the pure premium

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Question 3, p. 17

• There are several techniques for handling risks.
  For each of the following risks, identify an
  appropriate technique or combination of
  techniques that would be appropriate for dealing
  with the risk.
• A family head may die prematurely because of
  heart attack.
• An individuals home may be totally destroyed in
  a hurricane.
• A new car could be severely damaged in an auto
  accident.

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Question 3, p. 17 (cont.)

• There are several techniques for handling risks.
  For each of the following risks, identify an
  appropriate technique or combination of
  techniques that would be appropriate for dealing
  with the risk.
• A negligent motorist may be ordered to a pay a
  substantial judgment to someone who is injured in
  an auto accident.
• A surgeon could be sued for medical malpractice.
• An individual may be force to declare bankruptcy
  because he or she cannot pay catastrophic medical
  bills.

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Question 4, p. 17

• Andrew owns a gun shop in a high crime area. The
  store does not have a camera surveillance system.
  
• The high cost of burglary and theft insurance has
  substantially reduced his profits.

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Question 4, p. 17 (cont.)

• A risk management consultant points out that
  several methods other than insurance can be used
  to handle the burglary and theft exposure.
• Identify and explain two non-insurance methods
  that can be used to deal with the burglary and
  theft exposure.

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Question 5, p. 17

• Risk Managers use a number of methods for
  handling risk. For each of the following, what
  method for handling risk is used?
• The decision not to carry earthquake insurance on
  a firms main manufacturing plant.
• The installation of an automatic sprinkler system
  in a hotel

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Question 5, p. 17 (cont.)

• Risk Managers use a number of methods for
  handling risk. For each of the following, what
  method for handling risk is used?
• The decision not to produce a product that might
  result in a product liability suit
• Requiring retailers who sell the firms product
  to sign an agreement releasing the firm from
  liability if the product insures someone.

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Sample Quiz Question Chapter 1

• Insurance authors have traditionally defined risk
  as
• any situation in which the probability of loss is
  one.
• any situation in which the probability of loss is
  zero.
• uncertainty concerning the occurrence of loss.
• the probability of a loss occurring.

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Definition of Insurance

• Pooling of fortuitous losses
• by transfer to an insurer,
• who agrees to indemnify insureds for such losses,
  and
• render services connected with the risk.

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Basic Characteristics of Insurance

• Pooling of losses
• Payment of fortuitous losses
• Risk transfer
• Indemnification

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Requirements of an Insurable Risk

• Large number of exposure units
• to predict average loss
• Accidental and unintentional loss
• to control moral hazard
• to assure randomness
• Determinable and measurable loss
• to facilitate loss adjustment
• No catastrophic loss
• to allow the pooling technique to work
• Calculable chance of loss
• to determine the premium need
• Economically feasible premium
• so people can afford to buy

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Risk of Fire as an Insurable Risk
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War - An Insurable Risk?
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Sample Quiz Question Chapter 2

• Which of the following is implied by the pooling
  of losses?
• sharing of losses by an entire group
• inability to predict losses with any degree of
  accuracy
• substitution of actual loss for average loss
• increase of objective risk

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Loss Exposure

• Set of circumstances that presents the
  possibility of loss, whether or not a loss
  actually occurs.
• Implies the existence of something that may
  decline in value
• The object and the circumstances can be
  objectively verified

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Elements of a Loss Exposure

• The item subject to loss
• The perils, or forces that may cause the loss
• The potential financial impact of the loss

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Exposure Analysis Restaurant Example
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Direct Losses often Cause Indirect Losses

• Example What are the direct and indirect losses
  if a manufacturing plant experiences a major
  fire?

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Scooper Dooper Discussion

• Read the case.
• Identify 5 separate loss exposures
• Use the loss exposure schematic
• Valued thing
• Peril
• Financial consequence

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Pooling - Revisited

• Spreading losses incurred by the few over the
  entire group so that the average loss is
  substituted for actual loss.

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Two Assumptions Regarding Pooling

• The Pool consists of a group of risks that are
• Relatively homogenous
• Losses to which the group is subjected are
  accidental, not intentional

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Risk Pooling Example with 2 People

• Two people with same distribution
• Outcome Probability
• 2,500 0.20
• Loss
• 0 0.80
• Assume losses are uncorrelated
• Expected value 500
• Standard deviation 1000

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Risk Pooling Example with 2 People

• Pooling Arrangement changes distribution of
  accident costs for each individual
• Outcome Probability
• 0 (.8)(.8) .64
• Cost 1,250 (.2)(.8)(2) .32
• 2,500 (.2)(.2) .04
• Expected Cost 500

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Risk Pooling Example with 2 People

• Effect on Expected Loss
• w/o pooling, expected loss 500
• with pooling, expected loss 500
• Effect on Standard Deviation
• w/o pooling, standard. deviation 1000
• with pooling, standard. deviation 707

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Effect of Correlated Losses

• Uncertainty is not reduced as much
• Rationale
• If what happens to one person happens to others
• Then, one persons large loss does not tend to be
  offset by others small losses
• Therefore, pooling does not reduce risk as much

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Effect of Positive Correlation on Risk Reduction
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Law of Large Numbers

• The greater the number of exposures, the more
  closely will the actual result approach the
  expected result.

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EXHIBIT A2.1 Sampling Distribution Versus Sample
Size
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EXHIBIT A2.2 Standard Error of the Sampling
Distribution Versus Sample Size
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Insurance and Law of Large Numbers

• Insurance companies expect losses to occur.
• The major concern is the deviation between actual
  losses and expected losses.
• By insuring large numbers, insurance companies
  reduce their objective risk.

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Definition 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.

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Adverse Selection and Classification

• Adverse selection occurs when the insurer cannot
  classify, but the policyholders know their risk
• At a given price,
• high risk people will buy more coverage
• low risk will buy less coverage

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Heterogeneous Buyers

• Two groups of buyers
• One Group (MAPs middle aged professionals)
• Possible Loss Probability
• 0 0.95
• 10,000 0.05
• Another Group (YUMs young unemployed males)
• Possible Loss Probability
• 0 0.90
• 10,000 0.10

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Implications of Heterogeneous Buyers

• Our initial assumptions are that
• Equal number of each type
• Losses are Independent
• Full Insurance is mandatory
• Costless to distinguish MAPs from YUMs

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Implications of Heterogeneous Buyers

• Initial Scenario
• Equal Treatment Insurance Company is only insurer
• Premium for everyone 750
• Does Equal Treatment cover its costs?
• __Yes__, the YUMs pay less than their expected
  cost, but the MAPs pay more

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Implications of Heterogeneous Buyers

• New Scenario allow competition
• Competition from Selective Insurance Company
• If Selective assumes Equal Treatment will
  continue to charge 750, how does Selective set
  price to maximize profits,
• Premium to MAPs 600
• Premium to YUMs 1100
• Profit per policyholder 100

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Implications of Heterogeneous Buyers

• What happens to Equal Treatment?
• It would experience adverse selection
• I.e., it would obtain an adverse selection of
  policyholders -- only the YUMs will purchase from
  Equal Treatment
• Thus, Equal Treatment will have to classify or
  lose money

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Implications of Heterogeneous Buyers

• Key Points
• Profit Maximization
• gt Risk Classification
• Competition
• Lack of Classification
• gt Adverse Selection
• Competition

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Deductibles and Adverse Selection

• Insurer offers multiple policies with different
  deductibles and different prices per dollar of
  coverage
• Lower deductible (higher coverage) policies have
  a higher price per dollar of coverage
• Higher risk people might choose the lower
  deductible (higher priced) policies
• Lower risk people might choose the higher
  deductible (lower priced) policies

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Deductibles and Adverse Selection

• Result applicants separate themselves into
  different policy groups
• Thereby, permitting the insurance company to
  classify and underwrite risks in a low-cost way

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Similar Purpose of Policy Limits

• People have limited amount of wealth they want to
  protect
• Reduce classification costs when consumers have
  information that is costly for insurers to obtain
• Example
• Homeowners policy might limit coverage for
  jewelry losses to 1,500
• Those with more expensive jewelry buy special
  coverage
• Insurer does not have to investigate the value of
  each policyholders jewelry

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Risk Management

• A process that identifies loss exposures faced by
  an organization or individual and selects the
  most appropriate techniques for treating such
  exposures.

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Risk Management Vs. Insurance

• Risk management is a decision process insurance
  is a method of risk transfer
• Risk management focuses on identifying and
  measuring risks to select the most appropriate
  technique.
• Insurance is only one of several options to treat
  pure loss exposures.

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Pre-loss Risk Management Objectives

• Economy
• Reduction in anxiety
• Meeting legal obligations.

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Post-loss Risk Management Objectives

• Survival of the firm
• Continued operation
• Stability of earnings
• Continued growth
• Social responsibility.

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Farm Breeze Case

• Post-loss Objectives of Founder
• Post-loss Objective of Vice President of Marketing

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EXHIBIT 3.1 Steps in the Risk Management Process
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Sample Quiz Question Chapter 3

• Risk management is concerned with
• the identification and treatment of loss
  exposures.
• the management of speculative risks only.
• the management of pure risks that are
  uninsurable.
• the purchase of insurance only.

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Sample Short Answer Question

• What is the difference between risk and chance of
  loss?

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Syllabus - Revisited

• This course examines the principles of risk,
  insurance and the risk management process.
• The overall assumption of the course is that
  risks can only be managed if they are identified
  and treated prior to the loss.
• Insurance is an important tool, but not the only
  tool, available for that purpose.
• The course begins with an examination of risk and
  its meaning, and an overview of risk management
  process.
• The key terms used to differentiate among various
  kinds of risk are discussed.
• A framework is developed for identifying,
  analyzing and managing all types of risk.

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Syllabus Revisited (cont.)

• The evolving concept of enterprise risk
  management is introduced.
• The distinction between pure risk and other types
  of risk is clarified.
• Insurance is introduced as one of the options
  available to manage pure risk.
• Other options for treating pure risk are also
  reviewed, including loss control, risk retention
  and non-insurance risk transfer.
• A decision framework for selecting among these
  various tools is established.