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Principles of Risk Management and Insurance Chapters 1-4
Principles Of Risk & Insurance (RMI 2301)
St. John's University
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Chapter 1: Risk and its Treatments
● Risk: The fear concerning the occurrence of a loss Difference between Risk and Uncertainty: ○ Risk: The probability of the occurrence of a loss can be estimated with some accuracy ○ Uncertainty: Such probability cannot be estimated (sometimes a subjective guess exists) ● Risk managers often use the term “loss exposure” to describe potential losses: ○ Loss Exposure: Any situation or circumstance in which a loss is possible, regardless of
whether a loss occurs
Classification of Risk
● Pure Risk: There are only the possibilities of loss or no loss (earthquake, car accident) - [can be insured] ● Speculative Risk: Both profit or loss are possible (Gambling, stock exchange)
● Diversifiable Risk: Affects only individuals or small groups (car theft) It is also called nonsystematic risk or particular risk ● Nondiversifiable Risk: affects the entire economy or large numbers of persons or groups within the economy (hurricane). Also called systematic risk or fundamental risk ■ Gov. assistance may be necessary to insure nondiversifiable risks
Objective and Subjectivity Probability of a Loss
● Probability of loss: The probability that an event that causes a loss will occur ○ Objective Probability: Refers to the long-run relative frequency of an event based on the assumptions of an infinite number of observations with no change in the underlying conditions (is the same for different individuals) ■ Objective probabilities can be determined... 1. A priori: By logical deduction such as games of chance 2. Empirically: By induction, through analysis of data ● Subjective Probability: is an individual’s personal estimate of the chance of loss (varies between individuals) Objective Risk: the relative variation of actual loss from expected loss ● Can be measured by parameters that characterize the probability of destruction ○ Variance ○ Standard Deviation ○ Coefficient of variation ● A probability distribution is characterized by: ○ A mean (expected value), or measure of central tendency ○ A variance, or measure of dispersion
How to Measure Risk
John’s Case ● John is a reasonable person. He received an inheritance of $10,000 from an uncle. Now he is unsure of what to do with the money for investment purposes ○ His options: ■ 1. Store the money in a safe ● Payoff: $10, ● Probability: 1 ■ 2. Invest in a bond with 7% interest p. (Risk Averse person would choose this option) ● Payoff: $10, ● Probability: 1 ■ 3. Toss-a-coin Mutual fund ● Coin is tossed, if heads: he earns investment income of $3, ● If tails, he loses $1,500 of the principal ● Payoff: => $13,000 or $ ● Probability: 0 or 0.
○ Majority would choose to go with the bond
Another definition of Risk
Risk: The possibility of a (positive or negative) deviation from the expected outcome (ambiguous risk definition)
Measuring Volatility
● The variance are the squared differences to Expected Value multiplied with their probability ● The standard deviation is the square root of the variance ● The standard deviation is a measure for risk ○ it measures the average deviation from the mean ○ Higher standard deviations are associated with greater uncertainty of loss; therefore the risk is greater!
Another example of a probability distribution: ● Scheme for easy calculation of the mean:
Variance and standard deviation ● Variance is this probability distribution:
●
● The standard deviation is the square root of the variance ● The standard deviation is measured in the same units as the data
● The standard deviation = ● Higher standard deviations, relative to the mean, are associated with greater uncertainty of loss.., the risk is greater!
Risk attitudes/ Risk Neutrality
● An individual is assumed to be risk neutral if she is indifferent between any two lotteries with the same expected outcome (Expected Value) ● Choosing the outcome with the highest expected return is the optimal strategy for a risk neutral individual (using expected value theory)
● Risk-averse People - if he or she prefers to receive the Expected Value of a lottery for certain rather than owning the risky lottery ○ Choosing the outcome with the highest expected return, ex: using expected value theory, may not always be appropriate as it ignores the riskiness of a lottery! ■ A risk averse person prefers receiving 10,750$ to the lottery option three of john ■ A risk averse person prefers paying 90 cents to losing 10,000 with probability of .009% Why do people take out insurance? – Because they are Risk-averse ● Remember: a person is risk averse if he or she prefers a certain amount of wealth to a risky situation that yields the same expected wealth ○ This implies that given complete info about the risk, a risk averse person prefers full insurance over the uninsured situation if the insurance premium equals expected losses ● The person would even be willing to accept a premium loading (in addition to the expected losses), the maximum “tolerable” loading depending on the degree of risk aversion
The “Insurance Vocabulary”
● Peril: cause of the loss (in a car accident, the collision is the peril) ● Hazard: condition that increases the chance of loss or the severity of loss ○ Physical hazard: physical condition that increases the frequency or severity of loss (such as: icy streets, poorly designed intersections, dimly lit stairways, etc.) ○ Legal hazard: characteristics of the legal system or regulatory environment that increase the frequency or severity of loss ○ Moral hazard: dishonesty or characteristics of an individual that increase the chance or frequency of a loss ○ *Morale hazard: carelessness or indifference to a loss because of the existence of insurance ● But: recent theory of insurance usually defines moral hazard as: ○ insurance-induced changes of an insured’s behavior in the presence of asymmetric information ○ Moral hazard is NOT insurance fraud (= criminal intent!)
Insurance Fraud is a crime ● Types of Insurance Fraud with typically high loss amount: ● willful causation of loss ● fake of insured loss ● types of insurance fraud with typically low loss amount ● overstatement of size ● redefinition
■ Non-Diversifiable risk (b/c everyone can be a home buyer), Pure risk (in this situation), Financial risk ○ g) A worker on vacation plays the slot machines in a casino. ■ Speculative risk, Personal risk, Financial risk
Why does risk matter? ● Risk has several effects on society: ○ Reserves and Emergency Funds must be set aside for “rainy days” ○ Discontinuation of goods and services occur because of the risk of loss (Example: some companies will not operate in the U. for fear of lawsuits) ○ Risk can introduce worry and fear into our lives
SUMMARY OF CHAPTER 1:
● Risk has no single definition. It can be subjective or objective, pure or
speculative
○ Risk can be defined as the possibility of a (positive or negative) deviation from
the expected outcome
● Risk aversion means an individual prefers a certain amount of wealth to a risky
situation that yields the same expected wealth
○ Risk aversion is the major motive for insurance demand
● Enterprise Risk Management (ERM) combines into a single unified treatment
program all major risk a firm faces:
○ strategic risks, operational risks, and financial risks are all considered together
to lower the firm’s overall risk!
Chapter 2: Insurance and Risk Pooling
● Insurance: “Insurance is the pooling of fortuitous losses by transfer of such risks to insurers, who agree to indemnify for such losses, to provide other pecuniary benefits on their occurrence, or to render services connected with the risk.”
Basic Characteristics of an Insurance Arrangement:
Payment of fortuitous losses
A fortuitous loss is one that is unforeseen, unexpected, and occurs as a random result of chance
Risk transfer A pure risk is transferred from the insured to the insurer, who typically is in a stronger financial position Indemnification
Indemnification The insured is restored to his or her approximate financial position prior to the occurrence of the loss
Pooling of Risks Pooling is the spreading of losses incurred by the few over the entire group, so that in the process, average loss is substituted for actual loss
● Example: Samantha and Emily both face the risk of losing 2,500 $ with 20% chance (assume the events are independent, i., uncorrelated) ● Expected costs of the risk for each: 2,500 · 0 = 500 $
● Standard Deviation:
● This is the answer to
○ How much does the outcome differ from the mean on average?
● Samantha and Emily could enter an agreement to equally share losses:
● What happens to each person’s expected loss, standard deviation of loss, and maximum
probable loss?
● Let’s calculate expected loss, standard deviation, and PML for the shared loss distribution
● Maximum Probable Loss: 2, ● No reduction in Expected Loss and Maximum Probable Loss, but the standard deviation is reduced from 1,000 to 707
Risk pooling
● Additional risk reduction can be obtained by adding further individuals into the pooling agreement. ● First mutual insurance agreements evolved from this idea. ● Insurance companies manage risk pools and can therefore work with a reduced volatility. ● Insurance companies cannot share losses ex-post and therefore usually charge an insurance premium ex-ante to cover the potential losses. ● Correlations may play an important role! Law of Large Numbers
● Note that the Law of Large Numbers only applies to i.i. random variables ● In words: If the number of risks in the portfolio tends to infinity, the probability that the average outcome differs from expected value is positive tends to zero.
● But.. Law of Large Numbers and the Central Limit Theorem only hold if random variables are stochastically independent ● Would you assume stochastically independence in ○ Insurance portfolios? ○ Stock markets? Pooling with correlated losses ● Positive correlation vs. perfect correlation ● Remember Samantha and Emily?
Effect of Positive Correlation on Risk Reduction:
Pooling with correlated losses ● Pooling arrangements cannot reduce volatility if perfectly positively correlated ● Positive correlation leads to a reduction of standard deviation yet lower than without correlation
● Positive correlation is very common in insurance, stock or other markets, yet perfect correlation is rare
Characteristics of insurable risks
The six characteristics of an (ideally) insurable risk
Large number of exposure units Is necessary to predict the average loss based on the law of large numbers
Accidental and unintentional loss Because the law of large numbers is based on the random occurrence of events
Determinable and measurable loss ● Determinable: the loss should be definite as to cause, time, place and size ● Measurable: to determine how much should be paid
No catastrophic loss / limited loss size To allow the pooling technique to work ● Exposures to catastrophic loss can be managed by using reinsurance, dispersing coverage over a large geographic area, or using financial instruments, such as catastrophe bonds
Calculable probability of loss To establish a premium that is sufficient to pay all claims and expenses and yields a profit during the policy period
Economically feasible premium So people can afford to purchase the policy ● For insurance to be an attractive purchase, the premiums paid must be substantially less than the face value, or amount, of the policy ● Based on these requirements: ○ Most personal, property and liability risks can be insured
Risks should be quantifiable
● Problems of adequately estimating and quantifying the risk are often named a reason for (individual) lack of insurability (e. terrorist attacks). ● However: many decisions are based on “subjective” probabilities to some extent as definite probabilities are usually not available. ● Accordingly, boundaries of insurability concerning this criterion are usually rather subjective and somewhat fuzzy.
Correlation and total exposure
● Typical problem in some lines of business: dependencies such as accumulation risk and/or the risk of „infections“. ● Extreme loss potential possible due to accumulation (Ex: losses caused by windstorm) or very high individual losses possible (Ex: liability insurance for nuclear power plants).
SUMMARY of Chapter 2
● Insurers use risk pooling based on the Law of Large Numbers ○ Pooling means average loss is substituted for actual loss ○ This enables the policyholders to replace uncertain losses with a certain payment (the premium) ○ Risk averse individuals would always want to insure themselves at a fair premium (no loading) ● Adverse selection and moral hazard may cause failure of insurance markets ○ If not controlled by underwriting, adverse selection and moral hazard may result in higher-than-expected loss levels
Chapters 3-4: Introduction to Risk Management and Insurance
● Risk management: A scientific approach to handling risks by anticipating possible losses and designing and implementing procedures that minimize the occurrence of loss or the financial impact of the losses that do occur ● a process which attempts to minimize the cost of loss
Objectives of Risk Management
● Risk management has objectives before and after a loss occurs ● Pre-loss objectives: - Prepare for potential losses in the most economical way - Reduction of anxiety - continue operating ● Post-loss objectives (in order or importance) - Survival of the firm - Continue operating - Stability of earnings - Continued growth of the firm - Social responsibility
Risk Management Process (4 Steps)
- Identity
- Evaluate
- Select a Technique
- Avoid
- Retain
- Transfer (Insurance or Other Contractual)
- Control
- Implement and Monitor
Step 1: Identify loss Exposures ● Property loss exposures ● buildings, plants, structures ● computers, software, data ● furniture and equipment ● Liability Loss Exposures ● defective products ● environmental pollution ● discrimination, failure to promote ● Business Income Loss Exposures ● loss of income from a covered loss ● continuing expenses after a loss ● Risk managers have several sources of information to identify risks ○ risk analysis questionnaires, and checklists ○ financial statements ○ losses in past years ○ historical loss data ○ physical inspection ● Industry trends and Market changes can create new loss exposures (Example: exposure to acts of terrorism) ● Strategy Analysis: Involves planning and (sometimes short) term goals for an organization ● A SWOT analysis examines an organization's: ○ Strengths (Internal) ○ Weaknesses (Internal.) ○ Opportunities (external.) ○ Threats (external.) ● Which will affect its ability to meet strategic goals?
Step 2: Evaluate loss exposures ● Estimate for each type of loss exposure ○ Loss Frequency: probable number of losses that may occur during some time period ○ Loss Severity: the probable size of the losses may occur ● Rank exposures by importance ● Loss severity is more important than loss frequency: ○ Maximum Possible Loss: worst loss that could happen to a firm during its lifetime ○ Probable Maximum Loss: the worst loss that is likely to happen
● Self-insurance, or Self-funding: a special form of planned retention by which part or all of a given loss exposure is retained by the firm ○ Risk retention group (RRG): a group captive that can write any type of liability coverage except employers’ liability, workers compensation, and personal lines ■ Exempt from many state insurance laws
Advantages: ● Save on loss costs ● Save on expenses ● Encourage loss prevention ● Increase cash flow
Disadvantages: ● Possible higher losses ● Possible higher expenses ● Possible higher taxes
Non-Insurance Transfer: a method other than insurance by which a pure risk and its potential financial
consequences are transferred to another party ● Examples: contracts, leases, hold-harmless agreements
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
Disadvantages: ● Contract language may be ambiguous, so transfer may fail ● If the other party fails to pay, firm is still responsible for the loss ● Insurers may not give credit for transfers
Insurance: appropriate for low-probability, high-severity loss exposures
● The risk manager selects the coverages needed, and policy provisions ● A deductible is a specified amount subtracted from the loss payment otherwise payable to the insured ● In an excess insurance policy, the insurer pays only if the actual loss exceeds the amount a firm has decided to retain ● The risk manager selects the insurer, or insurers, to provide the coverages
Advantages: ● Firm is indemnified for losses ● Uncertainty is reduced ● Insurers can provide valuable risk management services ● Premiums are income-tax deductible
Disadvantages: ● Premiums may be costly ● Negotiation of contracts takes time and effort ● The risk manager may become lax in exercising loss control
Step 4: Implement and Monitor the Risk Management Program ● Implementation of a risk management program begins with a Risk Management Policy Statement: ○ Outlines the firmʼs objectives and policies ○ Educates top-level executives ○ Gives the risk manager greater authority ○ Provides standards for judging the risk managerʼs performance
■ The risk management program should be periodically reviewed ● Risk Management Manual: may be used to: Describe the risk management program and train new employees
SUMMARY of Chapter 3-
● Risk Management is beneficial to both firms and society
○ It enables the firm to attain its pre-loss and post-loss objectives more
easily
○ Risk Management Techniques include:
■ avoid, retain, transfer (insurance, other) and control
● A risk management program can reduce a firmʼs cost of risk
● Society benefits because both direct and indirect losses are reduced
Principles of Risk Management and Insurance Chapters 1-4
Course: Principles Of Risk & Insurance (RMI 2301)
University: St. John's University
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