Risk Management

Hurricane Katrina: Landfall August 29, 2005

Fair Bet
Cost Equals Expected Gain Cost = P * (Amount you Win) Example: Flipping a Coin
Cost = $10 P = .5 Amount You Win = $20

Is This A Fair Bet?

Flipping A Coin
Cost = $50 Amount You Win = $75

Risk Taking Behavior

Risk-Averse Risk-Neutral Risk-Taker (Risk-Seeker, Risk-Lover)

Risk and Uncertainty

Risk: A situation in which several different outcomes are possible. Uncertainty: The perception that several different outcomes are possible.
5

Categorizing Risk
Pure Risk v. Speculative Risk Diversifiable Risk v. Nondiversifiable Risk Fundamental Risks and Particular Risks

Pure Risks v. Speculative Risks

Speculative Risks are Usually Chosen Stock Appreciation Manufacturing and Selling a Product Example: Furby
Pure Risks are Usually a Byproduct Automobile Accident Sports Injury
7

Diversification
Pooling Similar Risks
INSURANCE

Pooling Offsetting Risks

A DIVERSIFIED PORTFOLIO

Why Reduce Uncertainty

Individual Corporations Government

Why Manage Risk? Individuals

Reduce anxiety

Planning

10

Why Manage Risks: Corporation

(Nexus of Contracts)
owners employees creditors

Corporation

suppliers customers

government

11

Early Historical Examples of Risk Management

Chinese Trading Boats

Amish Rebuilding

12

Modern Risk Management

Prior to 1950s: Insurance Purchaser Risk Managers
Finance Dept., Freestanding, or Human Resource Dept. Larger Companies Companies Facing Greater Risk
13

Risk Manager:
Minimize Adverse Consequences of Risk

Avoidance Loss Control Self-Insurance Purchase Insurance Anticipate Risk

14

The Decision to Manufacture a Product

15

Product Development: Motorcycle

Investment: $1,000,000 Profits if there is no Loss: $150,000 Possible Liability Losses:
1% Chance of $2,000,000 Loss

Required Return on Investment: 10%

16

Hiring an Employee

17

Hiring an Employee: Baseball Player with Drug Addiction

Salary: $200,000/year Financial Contribution to Club
$300,000 if Says Clean $50,000 if Uses Drugs Chance of Staying Clean: 50%

18

Major Duties of Risk Managers

Buy Insurance Identify Risk Loss Prevention and Loss Control Contract Review Safety Training and Education Govt. Compliance with Safety Issues Risk Finance Claims Mgmt. and Litigation Support Employee Benefits

19

Risk Management Process

Mission Identification Risk Identification Risk Analysis Consider Alternatives
Risk Control Risk Finance

Implement and Monitor

20

Mission Identification

Goal of Organization
Goal of Risk Management Department

21

Organization Goals
Corporation: Maximize Profits Non-Profit Organizations Religious Organization Hospitals

22

Organization Goals
Charities
Red Cross: The
American Red Cross, a humanitarian organization led by volunteers, . . . will provide relief to victims of disasters and help people prevent, prepare for, and respond to emergencies.

23

Post-Loss Objectives
Survival of the Organization Continuity of Operations Earnings Stability Continued Growth Social Responsibility
24

Pre-Loss Objectives
Economy Reduction in Anxiety
Owners Suppliers Lenders Customers Govt. Agencies

Meeting Externally Imposed Obligations Social Responsibility

25

Risk Management Process Step 2

Risk Identification and Analysis

26

Risk Identification: Key Terms

Hazard Risk Factor Peril Exposure

27

Difficulties with Risk Identification

New Laws
Examples: Building Codes, Clean Air Act
Examples: Black Lung, Second Hand Smoke Example: Product Liability Laws, Cigarettes

New Discoveries

Changing Societal Attitudes

28

New Laws and Risk Identification

29

Sources of Risk
Physical Environment Social Environment Political Environment Legal Environment Operational Environment Economic Environment Cognitive Environment
30

Social Environment and Disney Co.

Euro-Disney Powder Domestic Partner Benefits History Theme Park at Manassas

31

Example
Workplace Injury

32

Categories of Exposures
Property Exposures
Direct: Immediate Result Indirect: Secondary Results Example: Robbery of a Store

Liability Exposures Human Resource Exposures

33

Risk Identification Methods 1

Insurance Survey Risk Analysis Questionnaires Financial Statement Analysis Flow Chart Method Systems Safety Techniques

34

Risk Identification Methods 2

Interactions with External Resources Interactions with other Departments Past Losses On-Site Inspections

35

Accident Causation

Human Relations View Engineering View

36

Loss Analysis Ratios

Severity = $Losses / # Losses Frequency = # Losses / # Exposures

Expected Loss = $ Losses/ # Exposures

37

Ratios Example
Data
1000 Restaurants 50 Fires
Type 1 Fires: 20, $25,000 Type 2 Fires: 30, $50,000

Severity = [20($25,000) + 30($50,000)]/50 = $40,000 Frequency = 50 / 1000 = .05 Expected Loss = .05($40,000) = $2000
38

Concerns with Measuring Severity

Indirect Losses
Ex: Store robbery

Contagion
Ex: Foot-and-Mouth Disease

Snowball Effect
Ex: Mad Cow Disease
39

Contagion Example: Bil Mar

40

Contagion Example: Listeria

Chicago-based Sara Lee recalled hot dogs and deli meats produced at its Bil Mar plant in Zeeland, Michigan, after the CDC found listeria contamination in unopened packages of the products. Affected brand names include Ball Park, Bil Mar, Sara Lee Deli Meat and Sara Lee Home Roast. The states reporting listeria infections are Arizona, Connecticut, Georgia, Indiana, Iowa, Kentucky, Maryland, Massachusetts, Michigan, Minnesota, New York, Ohio, Oregon, Pennsylvania, Tennessee, Vermont and West Virginia.
41

Contagion Example: Listeria

Tainted meat
Killed 12 people Sickened 79 others in 16 states

241 workers fired or layed off

42

Loss Severity Measures

Maximum Possible Loss

Maximum Probable Loss

43

Example
Year 2003 2004 2005 2006 2007 Flights 5,000 5,000 5,000 5,000 5,000 Crashes 10 0 4 2 0 Losses $2,000,000 0 $1,000,000 $500,000 0

44

Loss Statistics
n Oi pi i1 freq mean = .2(.002)+.2(0)+.2(.0008)+.2(.0004)+.2(0)

Mean =

= .00064 sev mean = 10 (200,000) 6 (250,000) 16 16 = $218,750 E(L) = $140

45

Loss Statistics
S.D. =
n pi ( O i E V i ) 2 i1

Sev S.D. =

(10)(200,000 218,750)2 16 ( 6 )(250,000 218,750)2 16

= $26,791

46

Normal Distn Severity

Distance 1 S.D. 2 S.D. Prob 68.2% 95%

$218,750 $191,959 $165,168

[ [ [

$245,541 $272,332

freq = .00064 sev = $272,332 E(L)95% = $174.29

47

Calculating the Mean and Std. Dev.

Number of Fires 0 10 30 50 60 Probability .10 .20 .40 .20 .10

mean = S.D. =

.10(0)+.20(10)+.40(30)+.20(50)+.10(60) = 30 sq. root [.10(0-30)(0-30) +.20(10-30)(10-30) +.40(30-30)(30-30) +.20(50-30)(50-30) +.10(60-30)(60-30)] = 18.43

48

Important Distributions

Loss Frequency Distribution Loss Severity Distribution Total Loss Distribution

49

Loss Frequency Distn

Taxi Accidents N = 2000

Ot 0/2000 10/2000 30/2000 50/2000 60/2000

Pt .10 .20 .40 .20 .10

n E(Ot ) ptOt AvgFreq. t 1 0(.10) .005(.20) .015(.40) .025(.20) .03(.10) .015

.015(2000) = 30 Accidents
50

Loss Severity Distn

N = 100

Sevt $1,000 $2,000 $10,000 $50,000

n E(Sev ) (Sev )( pt ) i i1 i

Pi .80 .05 .10 .05

$1,000(.80) $2,000(.05) $10,000(.10) $50,000(.05) $4,400

51

Drawbacks to Use of Historical Data

CHANGE in Process

Insufficient Data

52

Importance of Timing of Losses

Time Value of Money

Cash Flow Considerations

53

Loss Triangles

Predict When Losses Will Occur Predict Total Losses Highlight Trends
54

Loss Triangle
Product Liability Suits
Loss Year
Year of Experience (ex. Year of Sales)
2003 2004 2005 2006 2007 2003 12 2004 16 16 2005 20 21 9 2006 22 26 12 8 2007 22 29 15 11 15

2008 = 15 x 1.337 = 20 2009 = 20 x 1.246 = 25

2010 = 25 x 1.1075 = 28 2011 = 28 x 1 = 28

55

Development Factors

Development Period Year of Experience

2003 2004 2005 2006 MEAN y+1 1.33 1.3125 1.33 1.375 1.337 y+2 1.25 1.238 1.25 y+3 1.10 1.115 y+4 1.00

1.246

1.1075

1.000

Examples 2003, y+1 = 16/12 = 1.33 2003, y+2 = 20/16 = 1.25

56

Loss Development: 2007 Sales Year

2007: 15 Losses

2008: 2009: 2010: 2011:

15 x 1.337 20 x 1.246 25 x 1.107 28 x 1.000

= 20 = 25 = 28 = 28

57

Present Value Calculation

Determining Losses from 2003 Sales
Claim Made in Year 2003 2004 2005 2006 2007 2008 2009 Losses 2003 Sales

i% 6% 6% 6% 6% 6% 6% 6%

Total Cost/Claim PV in 2003 # Losses Losses $10,000 $12,000 $14,000 $15,000 $18,000 $20,000 $24,000 $10,000 $11,321 $12,460 $12,594 $14,258 12 4 4 2 0 $120,000 $45,284 $49,840 $25,188 0

$240,312

58

Homework Problems

A) Determine the Number of Fully Developed Losses for 2004, 2005, and 2006. B) What is the PV of Losses Arising from 2005 Sales as of 2005?
59

Shapes of Different Distributions

Medical Expenditures Church Fires Parking Tickets

60

Normal Distribution

Bell Shaped Two Parameters Easy to Use

61

Property Losses

Property Exposed to Loss Peril Financial Consequences

62

Property Exposed to Loss

[ Real Property

[ Personal Property [ Non-owned Property

63

Non-owned Property
Bailed Property Leased Property Property on Consignment Employees Property Property under Lien Agency Relationships Contingent Property
64

Perils

Commonly Insured

Government Insured
Uninsurable

65

Commonly Insured Perils 1

Fire Lightning Windstorm Hail Explosion Smoke
66

Commonly Insured Perils 2

Aircraft & Vehicle Damage Riot Vandalism (Malicious Mischief) Falling Objects Weight of Snow, Ice, or Sleet Water Damage Glass Breakage Sprinkler Leakage Perils of Transportation Crime Perils
67

Difficult to Insure Perils

Earth Movement

Floods
Nuclear Reaction

68

Why Are Some Perils Uninsurable?

Against Public Policy Under the Control of the Insured
Ex. Suicide

Probability of Loss is Too High Simultaneous Destruction

69

Generally Uninsurable Perils

War, Terrorism, Rebellion, and Insurrection Intentional Losses Fading, Rust, Dry Rot, Settling Production, Marketing, and Political Risks
70

Financial Consequences
Reduction in Value Debris Removal Business Interruption Contingent Business Interruption Loss of Rental Income Loss of Rental Value Loss of Leasehold Interest Inability to Reconstruct Records Loss of Use Value in Improvements and Betterments Demolition Costs and Increased Cost of Reconstruction
71

Valuation of a Loss
Market Value Replacement Cost Actual Cash Value (Replacement Cost - Depreciation) Present Value of the Assets Contribution

72

Actual Cash Value Calculation: Building

Purchase
Date: January 1, 1987 Price: $1,000,000 Expected Lifetime: 40 years

Fire
Date: January 1, 2007 Replacement Cost: $2,000,000
73

Actual Cash Value Calculation: Building

ACV = Replacement Cost - Depreciation

As of the Time of Loss

ACV = $1,000,000 = $2,000,000 - $1,000,000

74

Present Value of the Assets Contribution

75

Liability Loss
Expenditure of TIME and MONEY Investigate, Negotiate, Defense, Payment

76

Property Losses v. Liability Losses

Parties Involved
Measurement of Exposure Changing Environment Tail
77

Types of Legal Liability

Criminal
Agent Punishments Insurance

Civil
Private Duties Common Law, Statutes, Contracts
78

TORT
Wrongful Act or Omission Independent of Contract Legal Remedy: DAMAGES ($$$)
79

Types of TORTS

Intentional Torts Negligence

Strict Liability
80

Intentional TORTS

Legally Protected Right Intentional Interference

Voluntary Damages Reasonably Foreseen No Valid Defense
81

Intentional Torts: Defamation

Types
Libel Slander

Plaintiff Must Show

False, Injurious Statement Publication Damages
82

Defenses
Truth
Privilege
Absolute Qualified
No Malice Not Known False No Intent to Injure Fair, if by news media Covered Body
83

Intentional Torts:
Invasion of the Right of Privacy

Examples
Release Confidential Information Hidden Microphones

Public Figures v. Private Figures

84

Intentional Torts:
Assault and Battery

Assault Battery Defenses

Consent Self-Defense Defense of Property Defense of Others Allowed Discipline
85

The Preppy Killer: Consent??

'Preppie killer' headed back to prison on drug rap
NEW YORK (AP) -- New York's so-called "preppie killer" is headed back to prison. Robert Chambers already served 15 years behind bars for strangling a woman in Central Park during what he said was rough sex. He pleaded guilty Monday to selling drugs. The Manhattan district attorney's office says Chambers is promised 19 years and four months in prison when he is sentenced on September 2. Chambers and his girlfriend were charged with dealing cocaine out of their Manhattan apartment in 2007.

Chambers pleaded guilty in 1988 to manslaughter in the death of 18-year-old Jennifer Levin two years earlier.
Stories portrayed him as a handsome, privileged, prep school youth gone bad. He was released from prison in 2003.

86

Intentional Torts:
Assorted Others
False Arrest and Wrongful Detention Malicious Prosecution Trespass Conversion Nuisance

87

Intentional Torts: Assorted Others Continued

Wrongful Interference with a Business Relationship
Copyright Infringement Deception

Bad Faith
Delaying Payment of Claims Refusing to Pay Claims
88

Negligence
Acts of Omission
Acts of Commission

89

Elements of a Negligent Act

Legal Duty
Breach Damages Proximate Cause
90

Damages
Compensatory Damages
Special Damages General Damages

Punitive Damages

91

Defenses to Negligence
Contributory Negligence Comparative Negligence Assumption of Risk Statute of Limitations Immunities
Sovereign Charitable Institutions Public Officials
92

Strict Liability Torts

Abnormally Dangerous Instrumentalities Ultrahazardous Activities Dangerously Defective Products Workers Compensation Statutes Disability Benefit Statutes Aviation Law Dram Shop Laws Contractual Assumptions
93

Goals of the Tort System

Compensate Deter

94

Tort Reform Proposals

Modify Joint and Several Liability

Caps on Non-Economic Damages

Caps on Punitive Damages

95

The Work Relationship

Employer
Sets Hours Defines and Supervises Work

Employee
Sacrifices Time for Income Is Told How to Work Method of Payment Not Important to Status

Independent Contractor
Not an Employee Controls Methods of Work
96

Workplace Injuries

Common Law: Negligence Statutory Law: Workers Compensation

97

Americas Most Dangerous Jobs in 2004

Rank 1

Occupation Logging workers

Death rate/100,000 92.4

Total deaths 85

2
3 4 5

Aircraft pilots
Fishers and fishing workers Structural iron and steel workers Refuse and recyclable material collectors

92.4
86.4 47.0 43.2

109
38 31 35

6
7 8 9

Farmers and ranchers

Roofers Electrical power line installers/repairers Driver/sales workers and truck drivers

37.5
34.9 30.0 27.6

307
94 36 905

10

Taxi drivers and chauffeurs

24.2

67

98

Some Exceptions to Workers Compensation

Small Firms

Farm Workers
Domestic Workers

99

Employers Common Law Duties

Safe Place to Work Adequate Number of Competent Fellow Employees Provide Safe Tools and Equipment Warn of Inherent Dangers Make and Enforce Safety Rules
100

Workers Compensation
Accident

Arising Out of and In the Course of Employment Only Bodily Injury

101

Workers Compensation Benefits

Lost Wages

Medical Care
Body Part Payments Death Benefits
102

Exceptions to WC as Sole Remedy for Workplace Injury

Assault by the Employer Retaliatory Discharge of the Employee Dual Capacity Doctrine Suits by 3rd Parties
Ex. Loss of Consortium Ex. Consequential Injuries

Property Damage
103

Human Resource Exposures

Loss of Personnel Cost of Employee Benefits

104

Employee Benefits
Attract Workers Retain Workers Retire Workers Encourage Productivity
105

Loss of Personnel
Premature Death Disability/Poor Health

Resign
106

Premature Death Losses that Result

Loss of Human Life Value

End of Life Expenses

Emotional Grief of Survivors

107

Premature Death Risk Management Strategies

Loss Prevention:
Medical Care Good Health

Life Insurance: Many are Underinsured Pension Plan Earnings of Surviving Spouse
108

Estimating Human Life Value

Example: Worker 3 years from Retirement

Year 2004 2005 2006 TOTAL

Output 50000 49000 48000

Pay 40000 38000 36000

Surplus PV(8%) 10000 11000 12000 10000 10185 10288 30473

109

Calculating Loss of Human Life Value

Worker dies at age 61 after being paid. At the time of death 3 working years remained.
Age 62 63 64 Total Earnings $40,000 $40,000 $40,000 Taxes $16,000 $16,000 $16,000 Self Family PV(8%) $14,000 $12,963 $12,003 $38,966

$10,000 $14,000 $10,000 $14,000 $10,000 $14,000

110

Disability Problem
Disability is comparatively frequent Disability can be extremely costly Most lost income due to disability is not replaced Disability insurance is confusing
Multiple definitions of disability

Disability insurance is subject to moral hazard

Malingering
111

Risk of a 90+ Day Disability v. Death

During Working Years

Age 22 62

P(Disability)/P(Death) 7.5 2

112

Risk Control
Avoidance Prevention Reduction Information Management Some Risk Transfers

113

Risk Avoidance
Proactive Avoidance

Abandonment

114

Drawbacks to Avoidance
Lost Benefits of Risk Perhaps not Possible
$ Government Imposed Risks $ Nature of the Risk

May Result in Worse Risks

115

Important Forms of Loss Reduction

Salvage Subrogation Litigation Management Catastrophe (or Contingency) Plans Duplication Separation
116

Information Management as Loss Control

Customers: Enhanced Sales Creditors: Lower Debt Cost Suppliers: Better Relationships Owners: Greater Market Value
117

Risk Transfer
Property or Activity Transferred

Contractually Pass the Liability

Exculpatory Contracts

118

Government and Risk Control

Public Interest Efficiency

119

Risk Financing: General Methods

Retention Transfer

120

Risk Financing: Timing

Contemporaneous

Prospective Retrospective
121

Approaches to Retention

Passive or Unplanned Active or Planned

122

Retention: Funding Arrangements

No Advance Funding Liability or Earmarked Accounts Earmarked Asset Accounts Captive Insurer
123

Types of Transfers
Insurance Noninsurance Transfers Hedging
124

Elements of Insurance
Contract
Premium Conditional Benefits Pooling of Resources
125

Insurance Transaction
Buyer Side of the Market
Risk Managers Brokers Consultants

Supplier Side of the Market

Insurance Company
Underwriters, Claims Adjusters, Agent, Actuaries

Agent
126

Noninsurance Transfers

Do Not Satisfy Conditions to be Insurance Provide External Funding

127

Hedging
Taking an Offsetting Risk

Not Possible for Many Types of Risks

128

129

130

131

Hedging Example

January 1: Arrange to sell chairs for $5.00 Raw materials today cost $2.50/chair June 1: July 1: Build chairs Deliver chairs

132

Hedging Example

Risk:

Cost of raw materials

Options:

1. Sell chairs on a cost + basis 2. Buy and hold raw materials 3. Buy and have seller hold raw materials 4. Use a hedge
133

Futures Contract
Owner of contract on Termination Date Receives the lumber

Price of contract depends on a) Cost of lumber today b) Risk Premium Origination Date: September 1 Termination Date: August 31.

134

Hedging Contract
January 1: Buy Hedging Contract Hedging Contract = $2.50 + x Lumber = $2.50 Risk Premium = x Buy Lumber & Sell Futures Contract Lumber = $2.50 + y Futures Contract = $2.50 + (x - z) + y Change in lumber cost = y Depreciation of risk premium = z Total Cost = ($2.50 + x) + ($2.50 + y) - ($2.50 + (x - z) + y) = $2.50 + z 135

June 1:

Hedging Contract Numerical Example

Origination Date: September 1 Termination Date: August 31. Original Risk Loading: 0.60 x = .40 x decreases .05 per month z = .05(5) = .25
Total Cost = $2.50 + .25 = $2.75
136

Hedging Instruments for Financial Risks

137

Hedging Volatility

Volatility is a measure of risk Some sources of volatility can be hedged

Interest Rate Exchange Rate Commodity Price

138

Interest Rate Volatility

Debt is a key component of a firms capital structure Interest rate hedges can stabilize borrowing costs Some tools: forwards, futures, swaps, options

139

Exchange Rate Volatility

International businesses are exposed to exchange rate risk Tools for managing exchange rate risk
forwards futures swaps

140

Commodity Price Volatility

Costs of materials can be volatile:
Pricing becomes problematic Sales demand becomes harder to predict

Hedging allows for:

Better production decisions Reduced volatility in cash flows

Available tools (depending on the type of commodity):

Forwards Futures Swaps Options
141

Reducing Risk Exposure

Hedging will not normally reduce risk completely
Typically, only price risk can be hedged not quantity risk Reducing risk completely causes loss of potential upside

Timing
Short-run exposure can be managed in a variety of ways Long-run exposure almost impossible to hedge

142

Forward Contracts
A contract between parties
Agreement today on the price of the asset on the delivery date Delivery and payment is specified for a future date

Forward contracts are legally binding on both parties Positions

Long: Short: Agrees to buy the asset on the future date Agrees to sell the asset on the future date

Key points
Negotiated contract No exchange of cash initially Usually limited to large, creditworthy corporations

143

Payoffs on Forward Contracts

144

Hedging with Forwards

Forward contracts can virtually eliminate price risk New risk created: Credit risk of the counterparty Forward contracts are primarily used to hedge exchange rate risk

145

Futures Contracts
Futures traded on organized securities exchanges
Upfront cash payment: MARGIN Small relative to the value of the contract Marked-to-market on a daily basis Clearinghouse guarantees contract performance Clearinghouse and margin requirements virtually eliminate credit risk
146

Hedging with Futures

Futures contracts are standardized
Allows for trading Exact hedging may be difficult or impossible

Credit risk is virtually nonexistent Futures contracts are available on

physical assets debt contracts Currencies equities

147

Swaps
A long-term agreement between two parties Can be viewed as a series of forward contracts Generally limited to large creditworthy institutions or companies

148

Option Contracts
The right, but not the obligation, to buy (sell) an asset for a set price on or before a specified date
Call right to buy the asset Put right to sell the asset Exercise or strike price specified price Expiration date specified date

Buyer has the right to exercise the option; the seller is obligated
Call option writer is obligated to sell the asset if the option is exercised Put option writer is obligated to buy the asset if the option is exercised

Options allow a firm to hedge downside risk, but still participate in upside potential
Pay a premium for this benefit
149

Payoff Profiles: Calls

Buy a call with E = $40
70 60 50
Payoff Payoff

Sell a Call E = $40

0 -10 0 -20 -30 -40 -50 -60 20 40 60 80 100

40 30 20 10 0 0 20 40 60 80 100 Stock Price

-70 Stock Price

150

Payoff Profiles: Puts

Buy a put with E = $40
45 40 35 30 25 20 15 10 5 0 0 20 40 60 80 100 Stock Price

Sell a Put E = $40

0 -5 0 -10 -15
Payoff

20

40

60

80 100

Payoff

-20 -25 -30 -35 -40 -45 Stock Price

151

Retention vs. Transfer

Ability to Bear the Loss Cost and Effectiveness of a Transfer Degree of Control over the Risk Insurance Loading Fees Additional Insurer Services Insurance as a Signal Opportunity Costs Taxes
152

Risk Financing Methods

Guaranteed Cost Insurance Experience-Rated Insurance Retrospective Rating
153

Guaranteed Cost Insurance

Underwriting Premium Depends on Classification Group Premium = (A)* (PURE PREMIUM) + B

154

Pure Premium
# cars = 10,000 # losses = 250 $ losses = $4.5 million Pure Premium = frequency x severity Frequency = 250 / 10,000 = 2.5% Severity = $4.5 million / 250 = $18,000 Pure Premium = 2.5% (18,000) = $450 A = 1.4 B = $50 1.4 (450) + 50 = $680

155

Underwriting Considerations
Adverse Selection Misclassification Control Civil Rights Costs of Classification Social Policy
156

Whats Fair and Why Health Insurance Underwriting Factors

Cigarette Smoking Obesity Age Prior history of heart disease Genetic Predisposition to Stomach Cancer Gender Race
157

State Underwriting Restrictions: Health Insurance

CALIFORNIA:
N. DAKOTA: WISCONSIN:

Blindness, Gender, Marital Status, DES

Blindness, Gender, Race Blindness, Gender, Physical Impairment

158

How Insurance Works An Example

Assume an individual has a 1% probability of getting cancer and incurring medical expenses of $200,000. How much would you charge to bear this risk?

159

How Insurance Works

Central Limit Theorem Mean = True Mean Law of Large Numbers Increase sample size by N New Mean = Old Mean x N New S.D. = Old S.D. x Sq. Root of N

160

HOW INSURANCE WORKS AN ILLUSTRATIVE EXAMPLE

Sample Size = 1,000 Mean = 10 S.D. = 2 Loss per claim = $200,000

S.D. Prob. 1 68.27 2 95.45 3 99.73

10

12

14

16

161

HOW INSURANCE WORKS AN ILLUSTRATIVE EXAMPLE

For 99.73% survival prob. insurer will charge: 16 x $200,000 = $3,200 1,000
Increase sample size to 100,000 (100x) Mean # of Losses = 10 x 100 = 1,000 S.D. = 2 x sqroot (100) = 20 Now for 99.73% survival prob. insurer will charge: 1060 x $200,000 = $2,120 100,000

162

Requirements of an Insurable Risk

1. 2. 3. 4. 5. Large Number of Homogenous Exposure Units Accidental Determinable and Measurable No Simultaneous Destruction Probability Calculable and Not Too High

suicide, space shuttle, mental illness, war, early flight and computers, terminally ill
163

Social and Economic Value of Insurance

Stability Indemnification Reduction in Reserve Funds Insurers Ability to Invest Satisfies Financial Requirements Specialization in Loss Prevention
164

Social Costs of Insurance

Insurers Operating Costs

Moral Hazard
Exaggeration of Losses

165

Cheating with Insurance

Insurer
Failure to Honor the Contract Misleading Contracts False Advertising Inappropriate Sales

Insured
Fraud
166

Controlling Cheating

Litigation Regulation

167

Litigation
Requirements of an Insurable Contract

Offer and Acceptance

Consideration
Competent Parties Legal Purpose
168

Litigation
Legal Principles: Indemnity
Valuation
Property: ACV Liability: Actual Damages

Apparent Exceptions
Valued Policies Replacement Cost Insurance Life Insurance
169

Actual Cash Value Example

ACV = Replacement Cost Depreciation 1/1/04: Buy Machine for $3,000, 10 year life 1/1/06: Fire Destroys Machine; New Machine Costs $10,000 ACV = $10,000 - $2,000 = $8,000

170

Litigation
Principle of Insurable Interest
Property and Liability: Time of Loss
Ownership Potential Legal Liability Secured Creditors

Life Insurance: Time of Policy Purchase

Close Ties: Love, Blood, Marriage Pecuniary Interest
171

Litigation
Principle of Subrogation

Prevents Double Indemnification

Holds Down Insurance Costs

172

Litigation
Principle of Utmost Good Faith

Representations Concealment Warranty

Is It Material?
173

Why Is Insurance Regulated?

Advance Payment of Premiums Complexity of Transaction

174

Types of Regulation
Licensing Solvency Rate Approval Agents Activities Insurance Contracts

175

Insolvency: Major Reasons

Bad Management Poor Underwriting Inadequate Reserves Bad Investing Inattentive to Loss Prevention Competitive Pressures

176

Danger of Insolvency
Most Insurers are Very Solid 100+ Years
71 Life Insurers 200 Property and Liability Insurers

Guaranty Funds Buyout of Failing Firms

177

Premium Regulation

Adequate Fair Reasonable

178

Methods of Rate Regulation

Prior Approval File and Use

Open Competition

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Advantages of Open Competition

Flexibility Increased Availability of Insurance Avoid Political Fights Frees Time of Regulators

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Disadvantages of Open Competition

Price Gouging (?)

Risk of Insolvency (?) Fair (?)

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Regulation of Agents Activities

Licensing Prohibited Acts
Twisting Rebating

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Causes of Insurance Market Failure

Adverse Selection Individuals Underestimate the Loss Potential Insurance Costs Too Much Pooling Not Possible Insurers Can Not Estimate the Loss Potential
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THE END

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