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Class 2 Insurance and Risk Management

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Title: Class 2 Insurance and Risk Management


1
Class 2 Insurance and Risk Management
  • George D. Krempley
  • Bus. Fin. 640
  • Autumn Quarter 2007

2
Bus. Fin. 640 Website
  • http//fisher.osu.edu/fin/autumn2007/640.htm

3
Methods of Handling Risk
  • Avoidance
  • Loss control
  • Retention
  • Non-insurance transfers
  • Insurance

4
Risk Management Matrix
5
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.

6
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.

7
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

8
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.

9
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.

10
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.

11
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.

12
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

13
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.

14
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.

15
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.

16
Basic Characteristics of Insurance
  • Pooling of losses
  • Payment of fortuitous losses
  • Risk transfer
  • Indemnification

17
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

18
Risk of Fire as an Insurable Risk
19
War - An Insurable Risk?
20
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

21
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

22
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

23
Exposure Analysis Restaurant Example
24
Direct Losses often Cause Indirect Losses
  • Example What are the direct and indirect losses
    if a manufacturing plant experiences a major
    fire?

25
Scooper Dooper Discussion
  • Read the case.
  • Identify 5 separate loss exposures
  • Use the loss exposure schematic
  • Valued thing
  • Peril
  • Financial consequence

26
Pooling - Revisited
  • Spreading losses incurred by the few over the
    entire group so that the average loss is
    substituted for actual loss.

27
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

28
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

29
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

30
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

31
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

32
Effect of Positive Correlation on Risk Reduction
33
Law of Large Numbers
  • The greater the number of exposures, the more
    closely will the actual result approach the
    expected result.

34
EXHIBIT A2.1 Sampling Distribution Versus Sample
Size
35
EXHIBIT A2.2 Standard Error of the Sampling
Distribution Versus Sample Size
36
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.

37
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.

38
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

39
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

40
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

41
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

42
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

43
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

44
Implications of Heterogeneous Buyers
  • Key Points
  • Profit Maximization
  • gt Risk Classification
  • Competition
  • Lack of Classification
  • gt Adverse Selection
  • Competition

45
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

46
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

47
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

48
Risk Management
  • A process that identifies loss exposures faced by
    an organization or individual and selects the
    most appropriate techniques for treating such
    exposures.

49
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.

50
Pre-loss Risk Management Objectives
  • Economy
  • Reduction in anxiety
  • Meeting legal obligations.

51
Post-loss Risk Management Objectives
  • Survival of the firm
  • Continued operation
  • Stability of earnings
  • Continued growth
  • Social responsibility.

52
Farm Breeze Case
  • Post-loss Objectives of Founder
  • Post-loss Objective of Vice President of Marketing

53
EXHIBIT 3.1 Steps in the Risk Management Process
54
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.

55
Sample Short Answer Question
  • What is the difference between risk and chance of
    loss?

56
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.

57
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.
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