11

Introduction toIntroduction to Risk and Insurance Risk and Insurance

22

Basic TerminologyBasic TerminologyRiskRisk

- not just uncertainty of financial loss;- not just uncertainty of financial loss;- possibility of deviation between - possibility of deviation between actual and expected outcomesactual and expected outcomes- measured in units called “exposures”- measured in units called “exposures”

33

InsuranceInsurance- not just transfer of risk;- not just transfer of risk;

- device for transferring, sharing, and - device for transferring, sharing, and reducing risk by combining a reducing risk by combining a sufficient number of exposure units sufficient number of exposure units to make individual losses collectively to make individual losses collectively predictablepredictable

44

Law of Large NumbersLaw of Large NumbersStatistical basis for insuranceStatistical basis for insuranceCrucial to the success of the productCrucial to the success of the productMost unique characteristic of Most unique characteristic of

insuranceinsuranceMakes Insurance a financial product Makes Insurance a financial product

different from any otherdifferent from any other

55

How Insurance reduces riskHow Insurance reduces riskAssume chance of a house loss is Assume chance of a house loss is

1/1001/100 If you have only one house, will yours If you have only one house, will yours

be that one?be that one?What if you have 10 house, will you What if you have 10 house, will you

have one burn?have one burn?What if you have 100 houses, will What if you have 100 houses, will

you likely have one burn?you likely have one burn?

66

How risk is reducedHow risk is reducedNeed to examineNeed to examineThe number of # exposuresThe number of # exposures (#)(#)Expected Losses (EL)Expected Losses (EL)Actual losses (AL)Actual losses (AL)Difference between actual and Difference between actual and

expected (Risk)expected (Risk)

77

How risk is reduced (cont.)How risk is reduced (cont.)## ELEL ALAL RiskRisk11 ?? ??100100 11 22 100%100%10001000 1010 1111 10%10%10,00010,000 100100 101101 1%1%100,000100,000 10001000 10011001

.1%.1%

88

Risk ManagementRisk Managementthe process of identifying and the process of identifying and

analyzing all possible loss analyzing all possible loss exposures, selecting a method of exposures, selecting a method of handling the exposure, and handling the exposure, and monitoring the method and monitoring the method and exposure regularlyexposure regularly

Who is a risk manager?Who is a risk manager?Who has practiced risk management Who has practiced risk management

personally?personally?

99

Basic Risk Management techniques:Basic Risk Management techniques:

risk avoidancerisk avoidancerisk control (hazard or loss reduction)risk control (hazard or loss reduction)risk retentionrisk retentionrisk transferrisk transfer

1010

Areas of ExposuresAreas of ExposuresTraditional AreasTraditional Areas Property LossesProperty Losses Liability LossesLiability Losses Net Income LossesNet Income Losses Personnel LossesPersonnel Losses

Recently Added AreasRecently Added Areas Corporate GovernanceCorporate Governance Management Liability ExposuresManagement Liability Exposures

1111

Common TerminologyCommon Terminology

Loss, Peril, HazardLoss, Peril, HazardPhysical, morale, and moralPhysical, morale, and moralLaw of Large NumbersLaw of Large NumbersLiability/CasualtyLiability/CasualtyThird Party ContractsThird Party ContractsNamed perils vs open perilsNamed perils vs open perilsDeductibleDeductible

to prevent over utilization of coverages to prevent over utilization of coverages to prevent filing small claimsto prevent filing small claims

1212

NegligenceNegligence Proximate CauseProximate Cause Reasonable Person RuleReasonable Person Rule Accident vs occurrenceAccident vs occurrence Bodily InjuryBodily Injury Property DamageProperty Damage Personal InjuryPersonal Injury

Not physical injuryNot physical injurydamage to reputation or mental statedamage to reputation or mental state

Advertising InjuryAdvertising InjurySame as PI but to a businessSame as PI but to a business

1313

ConditionalConditionalUtmost Good FaithUtmost Good FaithUnilateralUnilateralAdhesionAdhesionPersonalPersonalAleatoryAleatory IndemnityIndemnity

1414

IndemnityIndemnity Insurable InterestInsurable InterestSubrogationSubrogationACV Loss Measurement (versus ACV Loss Measurement (versus

valued/face amount contracts)valued/face amount contracts)Other Insurance ClauseOther Insurance Clause

Pro Rata ClausePro Rata ClauseOther Restrictive ClausesOther Restrictive Clauses

Policies enforcing indemnity: property, Policies enforcing indemnity: property, business income and extra expense, business income and extra expense, and liabilityand liability

Policies not contracts of indemnity: life Policies not contracts of indemnity: life insuranceinsurance

1515

Insurable Interest Insurable Interest Life Insurance:Life Insurance:

SelfSelfSpouseSpouseDependencyDependencyKey PersonKey Person

Property InsuranceProperty InsuranceOwnershipOwnershipCreditorCreditorsome leasing situationssome leasing situationslegal liabilitylegal liability

1616

How losses may be How losses may be measured:measured:

Face AmountFace Amount Actual Cash ValueActual Cash Value Replacement CostReplacement Cost Functional Replacement Cost (Repair Cost Functional Replacement Cost (Repair Cost

for functionally equivalent materials if for functionally equivalent materials if impossible to duplicateimpossible to duplicate

Stated ValueStated Value after loss, insurer may challenge and pay lessafter loss, insurer may challenge and pay less

Agreed ValueAgreed Value scheduled valuescheduled value

Fair Market ValueFair Market Value

1717

Reasons for Exclusions:Reasons for Exclusions:

May result in catastrophic lossMay result in catastrophic lossShould be covered elsewhereShould be covered elsewhereNot fortuitous (unexpected and Not fortuitous (unexpected and

unforeseen)unforeseen)To control moral or morale hazardsTo control moral or morale hazardsTo eliminate duplicate coverageTo eliminate duplicate coverageTo eliminate coverage not needed by To eliminate coverage not needed by

the average insuredthe average insured

1818

Underwriting ConceptsUnderwriting ConceptsUnderwriter - one who selects and Underwriter - one who selects and

categorizes riskscategorizes risksRequisites of an insurable risk:Requisites of an insurable risk:

the Law of Large numbers must applythe Law of Large numbers must applythe loss may not be intentionalthe loss may not be intentionalthe loss may not be susceptible to the loss may not be susceptible to

catastrophecatastrophethe loss must be economically significant to the loss must be economically significant to

the applicantthe applicantthe loss must be measurablethe loss must be measurable

Adverse SelectionAdverse Selection

1919

CoinsuranceCoinsurance In Health InsuranceIn Health Insurance

Purpose is to prevent unnecessary Purpose is to prevent unnecessary use of coverageuse of coverage

100% paid if loss is “severe”100% paid if loss is “severe” In Property InsuranceIn Property Insurance

Purpose is to promote rate equityPurpose is to promote rate equityAlternative system would be scaled Alternative system would be scaled

rating systemrating system Have / Should x Loss = $ amount paidHave / Should x Loss = $ amount paid

2020

Common Policy ClausesCommon Policy ClausesConcealment and FraudConcealment and FraudLiberalization ClauseLiberalization ClauseProof of LossProof of LossAppraisal ClauseAppraisal ClauseAbandonmentAbandonmentCancellation ProvisionsCancellation ProvisionsMortgagee ClauseMortgagee ClauseDuties After a LossDuties After a LossAssignmentAssignmentNo Benefit to BaileeNo Benefit to Bailee