Chapter 1 What is Risk 02 05 2014 Uncertainty concerning the occurrence of a loss o Skydiving o Rocky Mountain Climbing Note Insurance professionals use risk to identify the property or life that is being considered for insurance Sometimes you will hear risk referred to by those in the insurance industry as a piece of property or life being insured Because the definition of risk is sometimes ambiguous many authors or corporate risk managers use the term Loss Exposure to identify potential losses Loss Exposure Any situation or circumstance in which a loss is possible regardless of whether or not a loss occurs Types of Risk Objective Risk Degree of Risk o The relative variation of actual loss from expected loss Law 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 o Uncertainty based on a person s mental condition or state of Subjective Risk mind o A person s perception of a situation should I drive home after 6 drinks some would say yes others no Chance of Loss The probability that an event that causes a loss will occur Chance of Loss vs Objective Risk o The chance of loss may be identical for two different groups but objective risk may be different Example o 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 o 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 o The variation in Miami is greater than in Orlando and therefore Miami is riskier What is the chance a loss will occur Objective Probability o Measureable predictable outcomes At infinity o The long run relative frequency of an event based on the assumptions of an infinite number of observations and no change in the underlying conditions Example Mortality rates calculated by an insurer dice in a casino FL lottery 1 in about 23 million Subjective Probability o An individual s personal prediction of an outcome I m feeling lucky Lottery Gambling Talk about overestimating lotteries and underestimating catastrophes What Causes a Loss Peril Hazard o The cause of a loss Fire wind hail theft collision o Insurance coverage is often defined by perils o A condition that creates or increases the chance of a loss Poor electrical wiring Types of Hazards Physical Hazard o A physical condition that increases the chance of loss Broken lock icy roads slipper floor Legal Hazard o Characteristics of the legal or regulatory system that increases the frequency or severity of loss o Federal or state laws impose liability on firms individuals for participating in certain activities Swimming pools environmental cleanup adverse jury verdicts Moral Hazard o Dishonesty or character defects in an individual that increase the chance of a loss Insurance fraud inflating claims dishonesty Morale Attitudinal Hazard o Carelessness or indifference to loss because of the existence of insurance Leave car unlocked because it is worth more stolen Stop making updates to homes mechanics Doesn t have to be a conscious choice Peril vs Hazard A truck going out of control in a flooded parking lot What if the truck is Hydroplaning o Water is the physical hazard o Collision would be the peril What if the breaks are not working o Breaks are a physical hazard o Collision would be the peril What if the driver knew the brakes weren t great but figured it was ok because if he crashes he has insurance What if the driver is intentionally crashing the car for the insurance o Morale money o Moral Categories of Risk Pure vs Speculative Risk loss Pure Risk A situation in which the only outcomes are loss or no o Car crash house fire accident Speculative A situation in which profit or loss is possible o Stock market commodities gambling Fundamental vs Particular Risk Non Diversifiable Fundamental Risk Risk that affects the entire economy large numbers of persons or groups o Catastrophes o Recession or rapid inflation Diversifiable Particular Risk economy Car wreck Broken foot o Risk that affects specific individuals or groups not the entire Enterprise Risk business Enterprise risk encompasses all of the major risks faced by a o Pure and Speculative o Strategic Uncertainty regarding a firm s financial goals o Operational Uncertainty regarding a firm s activities or business operations o Financial 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 money Enterprise 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 Officer Types of Pure Risk Personal Risks Property Risks Liability Risks entity o Risk that directly affect an individual or family o The risk of property being damaged or destroyed o The risk of being financially responsible for damage to another Personal Risks Premature Death o Loss of income to the family o Additional expenses o Emotional trauma Risk of Poor Health o Loss of income again o Additional expenses physician services hospital fees Risk of Unemployment o Loss of income o Depletion of savings Risk of Insufficient Retirement Savings o Will social security be enough Medical expenses Loss of income is common theme with personal risks Personal risks generally affect the well being of an individual or family financially Property Risks Direct Loss o Financial loss from physical damage to property o Example McDonalds burns down and they need to rebuild o Example Your house is flooded and you have to repair Indirect Consequential Loss o Financial loss resulting from the loss of use of property stemming from a direct loss o Example McDonalds burns and they lose income o Example Your house floods and you have to rent somewhere else Liability Risks Anyone can be sued for any amount of damages o There is no maximum upper limit for a loss lawsuit o Defense costs can be very large as much or more than the lawsuit amount in some cases o A lien can be placed on your income or assets to assure payment of a judgment Examples o I hit someone with a car Broken leg Known damages auto insurance covers Death unknown damages what if
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