Risk Management Final Review

What is risk?
The uncertainty concerning the occurrence of a loss
Types of Risk
Objective Risk
Relative variation of the actual loss from the expected loss

Example: A prorpety insurer insures 10,000 homes with an expected loss of 100 homes to burn each year. However, the actual number of homes varies from 90-110. (The actual can be more or less than the expected)

To find the objective risk you take the variation amount and divide by expected loss [variation/E(L)]

Objective risk declines as the number of exposures increase – Law of Large Numbers

Law of Large Numbers
As the number of exposure units increase, the actual loss will approach the expected loss more closely
Subjective Risk
Uncertainty based on person’s mental condition or state of mind

High subjective risk, then the person takes a conservative & prudent behavior

Pure Risk
Loss or no loss

Adverse or neutral



Personal Pure Risks – Premature Death
Premature Death – a death of a family-head with unfulfilled financial obligations

This is based off of 4 characteristics

(1) Human Value of Life – The present value of deceased breadwinner’s future earnings
(2) Additional Expense
(3) Trouble making ends meet
(4) Non-economic costs

Personal Pure Risks
Risk of Insufficient Income During Retirement

Risk of Poor Health
– Payment of catastrophic medical bills
-Loss of earned income

Risk of Unemployment –
Usually due to a business cycle
(1) Lose Income
(2) Only can work part-time job
(3) Past savings & unemployment benefits have been exhausted

Property Pure Risks
Property – property damaged or lost

Direct – a result from a physical damage, destruction or theft of the property

Indirect – results indirectly from direct losses
There also can be added expenses that occur from either the indirect and/or direct losses

Liability Pure Risk
Liability Risk – legally liable if you do something that results in bodily injury or property damage to someone else

(1) No maximum upper limit with respect to the amount of the loss
(2) A lien may be placed on your income of financial assets to statsify legal judgement
(3) Legal defense can be enormous

Speculative Risk
A situation in which either profit or loss is possible

Examples: Stock market, betting on horse racing

Pure Risk v. Speculative Risk
(1) private insurers invest in pure risk
(2) Law of large numbers applies only to pure
(3) Society may benefit from a speculative risk even if a loss does occur

Example of #3: New technology

Fundamental Risk
Affects the entire economy or a large number of people/groups within the economy

Examples: Unemployment, War

Particular Risk
Affects only individuals
Fundamental Risk vs. Particular Risk
Government insurance is provided under fundamental risk

Example: Flood Insurance

Enterprise Risk
All major Risk faced by a business this includes:

Pure Risk
Speculative Risk
Strategic risk
Operational Risk
Financial Risk

Strategic Risk
Uncertainty regarding financial goals & objectives
Operational Risk
Uncertainty regarding a firms business operations
Financial Risk
Uncertainty regarding the loss because of adverse changes in commodity prices, interest rates, exchange rates and value of monies
Chance of Loss
The probability an event will occur.

There are two types:
Objective Probability

Subjective Probability

Objective Probability
Long run frequency that given infinite observation and no changes, a loss will occur

Deductive Reasoning – a priori probabilities

Example: A coin getting a head is 1/2

Inductive Reasoning

Example: How much coverage a 21 year old needs for a 5 year life insurance plan

Subjective Probability
An individual’s personal estimate of a chance of loss

Example: Someone believing they are extra lucky because it is their birthday

The cause of a loss; the COD on a death certificate

Example: Fire, collision

A condition that increases or creates the chance of a loss


Physical Hazard
A physical condition that increases the chance of loss

Example: A patch of ice

Moral Hazard
Dishonesty or a character defect

Wince people LIE to insurance companies, premiums are higher for everyone

Example: falsely reporting claims

Morale Hazard
Carelessness or indifference because the person has insurance

Example: leaving valuable in a unlocked car

Legal Hazard
Legal system or regulatory environment

Example: adverse jury verdicts,

Enterprise Risk Management
Combining a single unified treatment program to deal with all sorts of risk
Risk: Burdens on Society
(1) Emergency fund size must be increased
(2) Society is deprived of certain goods and services
(3) Worry and Fear are present
How to Handle Risk
(1) Avoidance
(2) Loss Control
(3) Retention
(4) Non-Insurance Transfer
(5) Insurance
How to Handle Risk: Loss Control
Loss Control – certain activities that reduce severity and frequency of loss
– Loss Prevention – reducing PROBABILITY of loss, the frequency is reduced
– Loss Reduction – reduce SEVERITY of a loss after it occurs

(1) Indirect loss >= direct loss
(2) Social cost of loss reduced

How to Handle Risk: Retention
Retention – retains all or part of the given risk

– Active Retention – consciously aware of the risk
(1) Save Money
(2) Insurance is unavailable/unaffordable
– Passive Retention – unknowinlgy retained
(1) ignorance, indifference or laziness

How to Handle Risk: Non-Insurance Transfer
Transferred to a party other than the insurance company

Can do this through:
(1) Contracts – hold-harmless clause – contract in which one party agrees to indemnify the other
(2) Hedging – forward purchase that locks in good or service over an extended period
(3) Incorporation of a business – personal assets cannot be attached to a creditor

How to Handle Risk: Insurance
(1) Risk Transfer
(2) Pooling technique
(3) Reduced by the Law of Large Numbers
Pooling of fortuitous losses by transfer of such risk 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 risks
Characteristics of Insurance – Pooling of Losses
Pooling of losses = sharing the losses
Spreading the losses incurred by the FEW over an ENTIRE group so that in the process, the AVERAGE loss is substituted for ACTUAL losses

(1) Sharing losses by entire group
(2) Prediction of future losses with accuracy

If future loss can be priced predicted, the objective risk goes down

Characteristics of Insurance – Payment of Fortuitous Losses
A loss that is unforeseen or unexpected and occurs as a result of chance
Characteristic of Insurance – Risk Transfer
Pure risk (yes/no) is transferred from insured to insurer, who is typically in a stronger position to pay the loss than the insured
Characteristic of Insurance – Indemnification
Indemnification – the insured is made whole – restored to approximate financial position prior to occurrence of the loss
What Makes a Risk Insurable?
(1) Large Number of Exposure Units
(2) Must be accidental and unintentional
(3) Determinable & Measurable
(4) Not catastrophic
(5) Must be calculable
(6) Economically feasible
Not Catastrophic
Ways to combat catastrophic risks

Reinsurance – is an arrangement by which the primary insurer that initially writes the insurance transfers to another insurer part or all of the potential losses

Disperse coverage over a large geographical area

Adverse Selection
The tendnecy of persons with higher than average chance of loss to seek insurance at a standard rate

Controlled by:
(1) Underwriting – process of selecting and classifying applicants for insurance

If it’s NOT MET – denied or pay an extra premium

(2) Policy Provisions
Example: Suicide clause

Gambling vs. Insurance
Gambling – creates a new speculative risk

Insurance – is a technique for handling an already existing risk

Gambling is socially unproductive beceuse the winner gains at the expense of the loser

Insurance is ALWAYS socially productive

Insurance v. Hedging
(1) Insurance – involves transfer of insurable risk
Hedging – technique for handling risks that are typically un-insurable

(2) Insurance can reduce the objective risk of an insurer by application of the law of large numbers

Hedging is only a RISK TRANSFER, not reduction

Types of Insurance
– Health & Life
– Property & Liability
– Property & Casualty
– Personal Lines
– Commercial Lines

– Social Insurance

Private Insurance
– Health & Insurance –
Life Insurance – Pays death benefits to designated beneficiaries when the insured dies
Examples: funeral expenses, un-insured medical bills, estate taxes
-Property & Liability –
Property – indemnifies property owner against the loss or damage of real/personal property
Liability – covers insured’s legal liability arising out of property damage or bodily injury to others
– Property & Casualty
Casualty Insurance – A Broad field of insurance that covers whatever is not covered by fire, marine & life insurance
(1) Personal Lines – coverages that insure the real estate and personal property of individuals and families
– private passenger auto insurance
– homeowners insurance
– personal umbrella liability insurance
– Boat owners insurance
(2) Commercial Lines – property & casualty insurance for business firm, non-profits and government agencies
– Fire Insurance
– Commercial multi-peril insurance
– General Liability
– Workers Compensation
– Commercial Auto insurance
– Accident & Health Insurance
Government Insurance
Social Insurance – a government insurance program with certain characteristics that distinguish them from other government plans

(1) funded by mandatory contributions
(2) right to receive benefit is ordinarily derived from recipients past contribution

Examples: Social Security, Medicare, Workers Compensation, Disability Act

Benefits of Insurance to Society
(1) Indemnification for loss
– As a result, can maintain financial secuirty
(2) Reduction of worry & fear
– Before AND after loss occurs
(3) Source of investment funds
– Increases society’s stock of capital goods which promotes economic growth and full employment
(4) Loss prevention – reduces both direct and indirect losses
(5) Enhancement of credit – greater assurance that the loan will be repaid
Cost of Insurance to Society
(1) Cost of Doing Business
– consume scare economic resources
– expense loading – the amount needed to pay for ALL expenses; this is justified by:
– uncertainty concerning the payment of a covered loss
– insurers engage in a wide variety of loss prevention activities
– provides jobs
(2) Fraudulent Claims
– results in higher premiums to all the insureds
(3) Inflated Claims
– Also Known As: Padded Claims
– the dollar amount of a claim may exceed the financial loss
– results in higher premiums, reduction of disposable income and consumption of goods/ services
Risk Management
The process that identifies loss exposures faced by an organization & selects the most appropriate techniques for treating such exposure
Loss Exposure
Any situation in which a loss is possible, regardless of whether a loss occurs
Risk Management Objectives
(1) Pre-loss
Economy – what will happen
Reduction of anxiety
Meeting legal obligations
(2) Post-loss
Survival of the firm
Continue Operating
Stability of Earnings
Continued Growth
Minimize the effects that a loss will on have other persons & society
Risk Management Process
(1) Identify loss exposure
(2) Analyze the loss exposure
(3) Select appropriate techniques for treating loss
Risk Control
– avoidance
– prevention
– reduction
Risk Financing
– retention
-non-insurance transfers
(4) Implement & monitor the risk management program
Identifying Loss Exposures
Types of exposures:
Business Income
Crime Loss
Employee Benefit
Foreign Loss Exposure
Public Image of Company


Analyze the Loss Exposures
Loss Frequency – the probable number of losses that may occur during some given time period
Loss Severity – probable SIZE of the loss that may occur

Maximum Probable Loss – Worst likely
Maximum Possible Loss – Worst possible

Selecting Appropriate Techniques to Treat the Loss
Risk Control – reduces the frequency & severity of loss
-Loss prevention
-Loss reduction — duplication/separation
Risk Financing
-Non-insurance transfer
Retention level – the dollar amount of losses that the firm will retain
-Maximum retention = 5%(Annual Earnings)
-Maximum retention = 5%(Net Working Capital)

Unfunded vs. Funded
– Unfunded – bookkeeping account that is charged with actual or expected losses from a given exposure
-Funded – setting aside of liquid funds to pay losses

Credit Line – From the Bank, borrowed funds may be used to pay losses as they occur, but you HAVE TO PAY INTEREST ON LOANS

A special form of planned retention by which part or all of a given loss exposure is retained by the firm


Retention Advantages
Saves money
Lower expenses
Encourages loss prevention
Increases cash flow
Retention Disadvantages
Possible higher losses
Possible higher expenses
Possible higher taxes
Non-Insurance Transfers
Methods other than insurance by which a pure risk and its potential finial which a pure risk an dits potential financial consequences are transferred to another party

Hold-Harmless Agreements

Captive Insurer – An insurer owned by a parent firm for the purpose of insuring the parent firm’s loss exposure
-pure captive – one parent
-group captive – several parents
Why are captive insurers formed?
(1) Difficulty obtaining insurance
(2) Lower costs
(3) Easier access to reinsurer
(4) Formation of a profit center
Insurance Steps
(1) Is Coverage Needed?
(2) What should the deductible be?
(3) Select insurer
(4) Terms of Insurance are negotiated
Manuscript policy
A Provision by which a specified amount is subtracted from the loss payment otherwise payable to the insured


Insurance Advantages
Indemnified after a loss occurs
Uncertainty reduced
Valuable risk management services
Income-tax deductible
Insurance Disadvantages
Payment of premiums are high
High time/effort costs
Less incentive to follow loss control program since insurance is in place
Implement & Monitor the Risk Management Program
Risk Management Policy Statement – outlines risk management objectives of firm

Risk Management Manual – describes IN DETAIL the risk management program of the firm

Personal Risk Management
Same steps as Commercial

Refers to the identification of pure risks faced by an individual or family & to the selection of the most appropriate technique for treating such risk

Legal Principles of Insurance
Principles of Insurable Interest
Principles of Utmost Good Faith
The insurer agrees to pay no more than the actual amount of the loss; THERE IS NO PROFIT FROM A LOSS

Helps to reduce moral hazard

Actual Cash Value
– Replacement cost – depreciation
– Fair Market Value = price a willing buyer would pay a willing seller in a free market
Example: E-bay

Exceptions to Principle of Indemnity
(1) Valued Policy – policy that pays the face amount of insurance if a total loss occurs
(2) Replacement Cost Insurance – no deduction for physical depreciation in determining the amount paid for a loss
Principles of Insurable Interest
Insured must be in a position to lose financially if a loss occurs

– prevent gambling
– reduce moral hazards
– measure amount of loss in property insurance

– Property Insurance: at the time of a loss
– Life Insurance: must be met only at the INCEPTION of the policy NOT the time of death

A substitution of the insurer in place of the insured for the purpose of claiming indemnity from a 3rd person

When/How does subrogation happen?
– after payment to insured
– insurer attempts to recover payment from responsible party

(1) prevents from collecting twice on same loss
(2) Used to hold the negligent person responsible for the loss
(3) Hold down insurance rates

Principles of Utmost Good Faith
Higher degree of honesty is imposed on parties to other contracts

Justification – high degree of information asymmetry

Elements of Utmost Good Faith
(1) Representations – statements made by applicant for insurance; contract voidable at insurer’s option if:
– material: if insurer knew true facts, the policy would not have been issued or would have been issued differently
– False – misleading
– Relied on by the insurer

(2) Concealment – intentional failure of the applicant for insurance to reveal a material fact to the insurer
– non-disclosure
– element of deception

Test for Concealment
– Did insured know of a certain fact?
– Was the fact material?
– Was the insurer ignorant of the fact?

(3) Warranties – Statement that becomes part of the insurance contract and is guaranteed by the maker to be true in all aspects

– promissory – condition to continue throughout contract period
– affirmative – exists at contract’s inception; promises nothing in the future

Utmost Good Faith
Insured can SUE INSURER
– Known as the bad faith claim
– used when insured feels insurer is not actin gin good faith; this forces companies to perform according to contract
Requirement Of An Insurance Contract
(1) Offer/Acceptance – applicant makes offer, insurer accepts/reject it
Binder – a temporary contract for insurance; can be oral or written
(2) Consideration – value each party gives the other
Insured – payment of premium
Insurer – specified in contract
(3) Competent Parties – must have legal capacity to enter into a binding contract
NOT OKAY: insane, mentally handicapped, intoxicated or minors
(4) Legal Purpose
Distinct Legal Characteristics of Insurance Contracts
(1) Aleatory – a contract where values exchanged may not be equal but depend on an uncertain event
(2) Communicative – values of exchange ARE equal
(3) Unilateral – only one party makes a legally enforceable promise
(4) Conditional – Insurance company’s obligation to pay a claim DEPENDS on whether the insured or beneficiary has complied with all policy conditions

Conditions – provisions inserted in the policy that qualify or place limitations on the insurers promise to perform

(5) Personal – Contract between insured and insurer
(6) Contract of Adhesion – Must accept the ENTIRE contract, with all of its terms and conditions


Principle of Reasonable Expectation
An insured is entitled to coverage under a policy that he/she reasonably expect it to provide
Insurance Company Operations
Rate Making
Claim Settlement
Other Insurance Company Functions
Rate Making
Price of insurance

Does not know in advance what actual costs will be

Actuaries – determine rates and premiums. The goal is to set pricing to make company profitable and competitive
(1) Set appropriate classes
(2) Develop reliable loss data for each class
(3) Convert data to develop final premium

Exposure Unit – unit of measurement used in insurance pricing

Extremely technical
Selection of classs os exposure units which collect statistics regarding probability and severity of loss

Rate Making Formula
Gross Premium = pure premium + (expense loading ratio x gross premium)

Gross Premium = pure premium /[1 – expense loading ratio]

Pure premium = Expected loss/ # of exposure units

Gross Premium Rate Determinants
Present value of expected claims
Present value of expense lading: Administration costs
Profit Loading – return/reward to investors for providing capital
Investment income – premiums decrease by amount of investment Income earned on premiums
*** as interest rates go up, premiums go down***
The process of selecting, classifying, and pricing applicants for insurance

Line underwriter – person who makes daily decisions concerning the acceptance or rejection of business

Underwriting Principles
(1) Must select prospective insureds according to the company standard
(2) Proper balance within each rate classification to help reduce adverse selection
(3) Equity among policy holders
(4) Balancing act – attain an underwriting profit
Steps in Underwriting
(1) Field Underwriting – which applications are acceptable
(2) Sources of underwriting information
– Application
– Agent Report – evaluation of prospective insured
– Inspector Report – outside firm investiages the applicant for insurance
– Physical Inspection
– Physical Examination
– MIB (Medical Information Bureau)
Underwriting Cycle
Hard Markets – high premiums, tight standards, not affordable

Soft Markets – Low premiums, loose standards, better for customer

Insurance Industry Capacity –
– Capacity – relative level of surplus; the greater the surplus, higher willingness to write new businesses/reduce premiums; maximum amount insurance can coverage

Combined Ratio
Ratio of paid losses and loss adjustment expenses plus underwriting expenses to premiums

CR = [losses + loss adjustment exp + underwriting expense]/premiums

ratio < 1 profitable

Insurance Company Profitability
Underwriting Premiums + Investment Revenue – Expenses (Losses, Loss Expenses & Underwriting Expenses) = Company Profit
Sales & marketing activities of insurers

Known as producers – agents who sell insurance

Agent – competent professional with a high degree of technical knowledge in a particular area of insurance and places the needs of the clients first

Special Agent – highly specialized technician who provides local agents in the field with technical help and assistance with their marketing problems

Claim Settlement
Verification a covered loss occurred
Fair & prompt payment of claims
Personal assistance to the insured
Unfair Claim Practices
(1) Refusing to pay claims without conducting a reasonable investigation
(2) Not attempting in good faith to provide prompt, fair & equitable settlements of claims
(3) offering lower settlements to compel insureds to institute lawsuits to recover amounts due
Types of Claims Adjustors
Agent – authority to settle small first-party claims
Company – a salaried employee who represents just one company
Independent – a person who offers services to insurance companies and is compensated by a fee
Steps in a Claims Process
(1) Notice of loss – notify insurer
(2) Investigation of claim – covered loss has occurred? amount?
(3) Filing a proof – proof of loss – sworn statement by the insured saying that substantiates the loss
(4) Decision Concerning payment
-Valid, but dispute over HOW MUCH
Policy provisions are set in place on how to deal with the dispute
Arrangement by which the primary insurer transfer to another insurer part or all of the potential losses associated with such insurance

Ceding company -primary insurer who writes business
Re-insurer – insurer that accepts insurance from ceding company
Retention Limit – amount of insurance retained by ceding company
Cession – amount of insurance ceded to re-insurer

Reasons for Reinsurance
(1) Increase underwriting capacity – write new business
(2) Stabilize profits – avoid large fluctations due to adverse loss conditions
(3) Reduce unearned premium reserve
Unearned portion of gross premiums on all outstanding policies at the time of valuation
(4) Provide protection against catastrophic loss
(5) Retire from business, line of insurance, or territory
(6) Obtain underwriting advice on a line for which an insurer has little experience
Types of Reinsurance
Facultative – case by case method that is used when the ceding company receives an application for insurance that EXCEEDS retention limit

Advantage – flexibility
Disadvantage – uncertainty

Treaty Reinsurance – primary insurer has agreed to cede insurance to re-insurer and re-insurer has agreed to accept it

Methods of Loss Sharing
Pro-rata – ceding company & re-insurer agree to share losses and premiums

Excess Method – re=insurer pays ONLY when covered losses exceed a certain level

Quota-Sharing Treaty

ceding insurer and re-insurer agree to share premiums and losses base don some proportion

Ceding commission

Premiums paid in advance, invested until needed

Investment income – reducing cost of insurance

(1) Long term – life; safety of principal’s primary consideration
(2) Short term – property; payments vary widely depending on losses

Other Insurance Company Function
EDP – Electronic Company Function
Accounting Department
legal Department
Loss – control Services