CH 1 Risk Its Treatment Risk A situation involving exposure to danger 01 30 2016 Uncertainty concerning the occurrence of a loss Possibility of loss on the person or entity that is insured Probability or threat of damage injury liability loss or other negative occurrence that is caused by external of internal vulnerabilities and that may be avoided through preemptive action Peril Cause of a loss Ex Collision of automobiles Hazard Condition that increases the chance of loss Physical hazard is a physical condition that increases the frequency or severity of loss Ex Ice Moral hazard is dishonesty or character defects in an individual that increase the frequency or severity of loss Ex Fraud on insurance Attitudinal hazard Who cares Ex Negligence Legal hazard The jury is out Moral and Legal Hazard go hand in hand Insurance regulations Ex Legal hazard can also result from laws or regulations that force insurance companies to cover risks that they would otherwise not cover such as including coverage for alcoholism in health insurance Classifications of Risk Pure Risk is a situation in which there are only the possibilities of loss or no loss earthquake Speculative Risk is a situation in which either profit or loss is possible gambling Diversifiable risk affects only individuals or small groups car theft It is also called nonsystematic or particular risk Ex Stock Market if you buy stock in agriculture and a draught hits these stocks will be the ones mainly affected not stocks that deal with car manufacturing Nondiversifiable risk affects the entire economy or large numbers of persons or groups within the economy hurricane flood It is also called systematic risk or fundamental risk Government assistance may be necessary to insure nondiversifiable risks i e the National Flood Insurance Program Classification of Risk Enterprise Risk Management combines into a single unified treatment program all major risks faced by the firm Pure risk Speculative risk Strategic risk Operational risk Financial risk Types of Pure Risk Personal Affects individual or family Ex Premature Death Poor Health Unemployment Property Destruction or theft of property Direct loss is physical damage as the damage a fire causes to a home Indirect loss is financial loss outside of physical damage such as losses that come when a family has to live elsewhere if a fire destroys a home Liability It s all your fault Liability risks involve the possibility of being held legally liable for bodily injury or property damage to someone else There is no maximum upper limit with respect to the amount of the loss A lien can be placed on your income and financial assets Legal defense costs can be enormous Major Commercial Risks Firms face a variety of pure risks that can have serious financial consequences if a loss occurs Property risks such as damage to buildings furniture and office equipment Liability risks such as suits for defective products pollution and sexual harassment Loss of business income when the firm must shut down for some time after a physical damage loss Other risks Crime exposures Human resource exposures theft cyber Foreign loss exposures Intangible property exposures Government exposures regulation Burden of Risk on Society Large amounts of personal emergency funds would be needed to repair damages without proper insurance People may lose access to goods or services such as a company fearing a lawsuit that would stop producing an important product Techniques for Managing Risk For most people insurance is the most practical method for handling major risks Hedging Two differnet actions to reduce risk Ex 10 dollar lottery ticket and money in a ETF fund Risk Control Avoidance Loss Prevention Loss Reduction Risk Financing Retention Self Insurance Transferring Hedging Incorporation Incorporation Company can bear risk Insights on the public s view of risk Natural disasters classified as low probability high consequence events are increasing in likelihood and severity Most people do not purchase insurance until AFTER suffering a severe loss from a disaster and then they often cancel it after several years For example flood insurance Individuals are not very good at assessing risk Public private partnerships can reduce the costs of future disasters i e building stronger homes People expect government to help if they have severe damage But government money is typically a loan not a handout Hurricanes get the headlines but other big risks are overlooked tornadoes CH 2 Insurance and Risk 01 30 2016 Insurance is the pooling of fortuitous losses by transfer of such risks to insurers who agree to indemnify insured s for such losses to provide other pecuniary benefits on their occurrence or to render services connected with the risk Characteristics Pooling of losses Payment of fortuitous claims Risk transfer Indemnification Pooling of losses Pooling spreads losses over the entire group Risk reduction is based on the Law of Large Numbers The greater the number of exposures the more closely the actual results will approach the probable results that are expected from an infinite number of exposures How Insurance Works Payment of fortuitous losses Unforeseen unexpected and occurs as a result of chance Risk transfer Pure risk transferred from insured to insurer Indemnification Insured is restored to the financial position prior to the loss Characteristics of an Ideally Insurable Risk 1 Large number of exposure units to predict average loss based on the law of large numbers 2 Accidental and unintentional loss to assure random occurrence of events 3 Determinable and measurable loss to determine how much should be paid 4 No catastrophic loss 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 5 Calculable chance of loss to establish a premium that is sufficient to pay all claims and expenses and yields a profit during the policy period 6 Economically feasible premium So people can afford to purchase the policy For insurance to be an attractive purchase 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 Market risks financial risks production risks and political risks are difficult to insure Adverse selection is the tendency of persons with a higher than average
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