RMI3011 Test 1 Study Guide• Risk – the possibility of loss, involves uncertainty. At least one outcome is undesirable. Has negative financial consequences.o Objective risk is measurable. o Subjective risk is how we interpret the event. o Law of large numbers – the larger the sample size, the more likely it is that you’ll obtain the expected results. o Pure risk- loss/no loss possibleo Speculative risk – gain possible (gambling)o Fortuitous losses are neither expected nor intended (accidental) o Fundamental risk affects us allo Particular risk is uniqueo Enterprise risk is all the things that can happen to a business or firmo Peril – the cause of loss (HOW)o Hazard- the condition that increases the possibility of loss (WHY) o Physicalo Moral – fraud, arsono Morale- carelessness or indifferenceo Legal- a dog biting someone, liability• Types of Risko Personal- premature death, poor health, unemployment, outliving your retirement income.o Property- direct loss, indirect loss, extra expense.o Liability- negligence, warranty, absolute, defense cost. • Risk Treatment Methodso Avoidanceo Prevention- reducing frequencyo Reduction- reducing severityo Retention- involves deductibles. Active- insurance Passive- not buying insuranceo Transfers- transferring the negative financial consequenceo Insurance• Insurance- a small certain sum in exchange for a large uncertain sumo Pooling of exposures- everyone pays their fair shareo Only works for fortuitous losseso Transfers the negative financial consequenceso Indemnification- putting you in the same place (financially) after the loss as you were before the loss.o Large number of homogenous unitso Calculates the loss probability using the Law of Large Numberso Fortuitous/random losseso Affordable premium• Adverse Selection- a higher risk person trying to obtain reasonable rateso Underwriting reduces this possibility o Policy Provisions also help control thiso Application Process makes sure the person is being truthful• Insurance vs Gambling – gambling creates speculative risk• Types of Insuranceo Life/Health/Annuityo Property and Casualtyo Private Insurance- voluntary, you can choose where to buy fromo Government Insurance- compulsatory• Benefits of Insuranceo Reduces uncertaintyo Eliminates need for reserve fundo Creates capitalo Compensation for losso Promotion of loss avoidance techniqueso Enhances credit• Cost of Insurance o Cost of doing business (taxes)o Moral hazard- fraudulent claims and inflated claims• Risk Management- the process to identify exposures and select the treatment of an economic entity’s (personal or business) exposure to loss.o Risk Control- minimizing the frequency or severity of losses (BEFORE THE LOSS)o Risk Financing- minimizing the financial impact of the loss once occurred (AFTER THE LOSS)• Risk Management Objectiveso Pre-Loss- affordability, reduction of anxiety, meets the legal obligationso Post-loss- survival of the firm, continued operations, stability of earnings, continued growth, social responsibility • Risk Management Processo Identify loss exposureso Evaluate potential losses (max possible vs max probable) o Select treatment procedureso Implement and Administer the program• Loss Ratio – losses/premiums• Expense ratio- overhead+expenses/premium• Combined ratio- add the two together• Rate Making in Propery and Casualty Insurance- adequacy, not excessive, not unfairly discriminatoryo Class rating- classifying people, majority of insurance ratingo Merit rating- plus or a minus, take the individual characteristics and gives them a credit or a debit. Rewards/penalizes• Life Insurance Rates- based on mortality tables, based on rate per thousand, law of large numbers• Government Regulation of Insuranceo Maintains insurance solvencyo Compensates for consumer ignoranceo Reasonable rateso Availability• Historical development of insurance regulationo Paul vs Virginia (1868) Paul sued Virginia because he wanted to sell insurance there. Said states should regulate the insurance. o Southeastern Underwriters Association Case (1944) Supreme court ruled that Federal Government should regulate insuranceo McCarran-Ferguson Act (1945) Repealed the above act, insurance should be regulated by the states. o Financial Modernization Act (1999) Allowed banks to own insurance companies and vice versa. • Regulationo State and federal lawso Court systemo Taxation• Current Issues in Insurance Regulationo Contingent commissionso Accounting Practiceso Modernization• Legal Principals in Insurance Contractso Indemnityo Insurable Interest- must exist at time of loss for property and at time of application for life insurance.o Actual Cash Value- replacement cost less depreciation o Subrogation- the at-fault party is held liable for the damages• Insurance is a Contract of Utmost Good Faith and has a higher standard of truthfulness o Misrepresentation during the application process may lead to a voided contracto Concealment is the failure to disclose something that a prudent person would think important to discloseo Warranty is the “unless” clause in the contract, ie- you may not drive your boat more than 50 miles offshore.• Enforceable Contractso Must have Offer and Acceptance- the application is the offero Consideration- paying the premium, abiding by the terms. The insurance company has a legally binding promise to abide by.o Legal Purpose- you can’t insure cocaine, a stolen car, etc.o Competent Parties- 18 or older, mental capacity, not insane, etc.o Legal form- not necessarily in writing• Characteristics of Contractso Adhesion- take it or leave ito Unilateral- only one party makes a legally binding agreemento Personal- covers only the person statedo Aleatory- values exchanged are not equalo Conditional- if you do not abide by the terms, the contract may be voided. • Legal Doctrineso Waiver- voluntary relinquishment of a known legal righto Estoppel- representation of fact by an Agent, consumer relied on representation, principal is bound by Agent’s representation• Parts of an insurance contracto Declarations page- information page, unique to youo Definitionso Insuring Agreemento Exclusions- things that aren’t covered by insuranceo Conditions- what you must abide by in order to have coverageo Endorsements- add, subtract, modify or clarify the contract to change coverageo Deductibles- used to eliminate small claims and to reduce premiums• Coinsurance-
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