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FSU RMI 3011 - Chapter 1

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What is Risk?Uncertainty concerning the occurrence of a lossSkydivingRocky Mountain ClimbingNote: Insurance professionals use risk to identify the property or life that is being considered for insuranceSometimes you will hear risk referred to by those in the insurance industry as a piece of property or life being insuredBecause the definition of risk is sometimes ambiguous, many authors or corporate risk managers use the term “Loss Exposure” to identify potential losses.Loss ExposureAny situation or circumstance in which a loss is possible, regardless of whether or not a loss occursTypes of RiskObjective Risk (Degree of Risk)The relative variation of actual loss from expected lossLaw of large numbers: Objective risk decreases as exposure units increase. As the number of exposure units increases, the more closely the actual loss experience will approach the expected loss experience.Subjective RiskUncertainty based on a person’s mental condition or state of mindA person’s perception of a situation – should I drive home after 6 drinks – some would say yes, others noChance of LossThe probability that an event that causes a loss will occurChance of Loss vs. Objective RiskThe chance of loss may be identical for two different groups, but objective risk may be differentExample:Miami and Orlando both have 10,000 total automobiles.Miami had 125, 100, and 75 accidents in 2010, 2011, and 2012, respectively.Orlando had 100, 90, and 110 accidents in 2010, 2011, and 2012, respectively.Which city is riskier?What’s the chance of loss, how many accidents are expected in Miami - 100.How many accidents are expected in Orlando – 100.But do they both have the same risk?? NO.The variation in Miami is greater than in Orlando and therefore, Miami is riskierWhat is the chance a loss will occur?Objective ProbabilityMeasureable, predictable outcomes (At infinity)The long-run relative frequency of an event based on the assumptions of an infinite number of observations and no change in the underlying conditionsExample – Mortality rates calculated by an insurer, dice in a casino, FL lottery 1 in about 23 millionSubjective ProbabilityAn individual’s personal prediction of an outcomeI’m feeling lucky (Lottery)GamblingTalk about overestimating lotteries and underestimating catastrophes.What Causes a Loss?PerilThe cause of a loss (Fire, wind, hail, theft, collision…)Insurance coverage is often defined by perilsHazardA condition that creates or increases the chance of a loss(Poor electrical wiring)Types of Hazards:Physical HazardA physical condition that increases the chance of lossBroken lock, icy roads, slipper floorLegal HazardCharacteristics of the legal or regulatory system that increases the frequency or severity of lossFederal or state laws impose liability on firms/individuals for participating in certain activitiesSwimming pools, environmental cleanup, adverse jury verdictsMoral HazardDishonesty or character defects in an individual that increase the chance of a lossInsurance fraud, inflating claims, dishonestyMorale (Attitudinal) HazardCarelessness or indifference to loss because of the existence of insuranceLeave car unlocked because it is worth more stolenStop making updates to homes mechanicsDoesn’t have to be a conscious choicePeril vs. HazardA truck going out of control in a flooded parking lot:What if the truck is Hydroplaning?Water is the physical hazardCollision would be the perilWhat if the breaks are not working?Breaks are a physical hazardCollision would be the perilWhat if the driver knew the brakes weren’t great, but figured it was ok because if he crashes he has insurance?MoraleWhat if the driver is intentionally crashing the car for the insurance money?MoralCategories of Risk:Pure vs. Speculative RiskPure Risk: A situation in which the only outcomes are loss or no lossCar crash, house fire, accidentSpeculative: A situation in which profit or loss is possibleStock market, commodities, gamblingFundamental vs. Particular RiskNon-Diversifiable (Fundamental) Risk: Risk that affects the entire economy, large numbers of persons, or groupsCatastrophesRecession or rapid inflationDiversifiable (Particular) RiskRisk that affects specific individuals or groups (not the entire economy)Car wreckBroken footEnterprise RiskEnterprise risk encompasses all of the major risks faced by a businessPure and SpeculativeStrategic – Uncertainty regarding a firm’s financial goalsOperational – Uncertainty regarding a firm’s activities or business operationsFinancial – Uncertainty regarding the value of money.Refers to the uncertainty of loss because of adverse changes in commodity prices, interest rates, foreign exchange rates, and the value of moneyEnterprise Risk Management – Combines into a single unified treatment program all major risks faced by the firm. Allows for the management of risks simultaneously.CRO – Corporate Risk OfficerTypes of Pure RiskPersonal RisksRisk that directly affect an individual or familyProperty RisksThe risk of property being damaged or destroyedLiability RisksThe risk of being financially responsible for damage to another entity.Personal RisksPremature DeathLoss of income to the familyAdditional expensesEmotional traumaRisk of Poor HealthLoss of income (again)Additional expenses (physician services, hospital fees)Risk of UnemploymentLoss of incomeDepletion of savingsRisk of Insufficient Retirement SavingsWill social security be enough?Medical expensesLoss of income is common theme with personal risksPersonal risks generally affect the well-being of an individual or family financiallyProperty RisksDirect LossFinancial loss from physical damage to propertyExample: McDonalds burns down and they need to rebuildExample: Your house is flooded and you have to repairIndirect (Consequential) LossFinancial loss resulting from the loss-of-use of property stemming from a direct lossExample: McDonalds burns and they lose incomeExample: Your house floods and you have to rent somewhere elseLiability RisksAnyone can be sued for any amount of damagesThere is no maximum upper limit for a loss/lawsuitDefense costs can be very large – as much or more than the lawsuit amount in some casesA lien can be placed on your income or assets to assure payment of a judgmentExamples:I hit someone with a carBroken leg…Known damages auto insurance coversDeath…unknown damages, what if they are breadwinner. What if I am drunkPremises, auto, products, EPL, pollution,


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