Risk exam 2 notes PDF

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TOPIC 6 Risk Financing Deals with Sources of Funds to Pay for Losses 1. External Funds (someone else pays) 2. Internal Funds (organization pays) 3. Alternative Risk Financing Technique Risk Transfer of the Financing Type - Seek funds from an unrelated 3rd party to pay for the loss - Transfer the financial responsibilities of a loss to a third party I. Types 1. Insurance – transfers the financial responsibilities of loss to insurer 2. Contractual Risk Transfer – Hold harmless… agreements allow one party to transfer the responsibility to pay for their negligence to someone else a. Property owner had demolition contractor promise this in their contract b. Lease agreement: (backed up by the other party’s insurance or assets) 3. With both of these, the financial responsibility for the loss of that is “being transferred” can return to the original organization a. If your rich, you need more insurance to cover yourself II.

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Retention – organization retains the loss exposure (not buying insurance) 1. Active Retention – Firm knowingly retains the exposure for a loss a. Example: temple 10 million deductible on property insurance 2. Passive Retention – unaware they retained the exposure typically from failure to identify risk or underestimates the loss exposure. a. Clients not buying cyber insurance b. First job – dental or disability insurance 3. Funded Retention – Firm budgets fro this loss and sets aside money a. Alamo Car Rental is an example 4. Unfunded Retention – firm does not have separate fund and will pay from current revenue Low frequency, and high severity is good situation where you should buy insurance Unfunded is when you have low severity and low frequency. Self Insurance Formal and Planned funded retention can be used on bigger scales 1. Health/ medical insurance benefits for employees (200 plus) a. Example: worker’s compensation benefits for on the job injuries a) Fairly predictable if the firm is large enough b) Long payout period (cash & time value of money) b. Allows for pre-funding of “known loss”, cash flow benefit, loss forecasting, accrue for the expense, long- tail loss(not immediate loss)

Advantages 1. Potentially less expensive 2. Expected cost of self insurance is less than know cost of market insurance a. No risk charge b. No marketing expense c. Money can be invested (cash flow) d. No commissions 3. Money can be invested internally 4. Firms can retain the benefits of successful loss prevention and loss reduction programs a. Reduces “moral hazard associated with insurance company who buys insurance company could think – “I don’t care if it happens since it is the insurance company’s money” b. Firm has “skin in the game” 5. Flexibility of design of a firm’s health insurance plan a. Health insurance contracts are full of state mandated benefits increase the cost of coverage i. Must pay increased premium in Maryland and New Jersey for Vitro Fertilization, not in PA Disadvantages 1. Possibility of catastrophic loss (octa-mom, cystic fibrosis) a. Firms need to buy Stop Loss Insurance – like an insurance contract with a very large deductible b. Specific retention – by firm for a single loss and then insurance coverage above that (100k) c. Aggregate Retention – by firms for the total amount of losses from all events in a year 2. Firms have to perform many of the administrative cost/ activities that would have been done by the insurance company a. Claim settlements – buy an ASO contract (Administrative service only) – some health care card and access to the discounts in insurance company healthcare provider networks 3. Cant blame the insurance company on claim settlement problems 4. Hard to jump back into the standard insurance market 5. Income tax treatment of premiums v. losses (timing differences) a. Firm buys insurance – full cost is deductible that year b. Firm decides to self insure – only the costs paid in each year are deductible c. Impact the CFO’s financial statements – tax code biases a firm’s decision toward buying insurance v. self insurance due to earlier timing of expense deduction

TOPIC 7 BETTER EXPLAINED IN WS Loss Matrix – indicates the possible dollar values or expenditures associate with each combination of Risk Management alternatives and future state of the world First Example (LOSS OR NO LOSS) 1. Fire occurs – assume that a loss is a total loss (3%) 2. No fire – No loss (97%) 424,000 or 0 damage Possible options 1. Retention 2. Retention and Safety Measurement a. Loss prevention (cost = 12,000) b. Decrease frequency but no impact on severity 1% fire or 99% none 3. Full Insurance a. Face amount = 424,000 b. Premium = 20,000 Expenses- all are tax deductible  Insurance Premiums  Cost of Safety  Cost of uninsured losses 2 types of costs 1. Monetary Cost (expected loss) 2. Non – Monetary Cost (worry value) Worry Value – cost associated with decision making or the cost of anxiety concerning the uncertainty of a decision (unique to decision maker) Actuarially fair premium  AFP insurance with a premium= P*(expected loss) only (the pure premium)  Premium = $12,720 (self- insured value) PMAX- max premium a person is willing got pay for insurance for a particular risk PMAX (minus) P* = worry value Worry Value = Max amount over P* that a person is willing to pay to for insurance A Person’s/ Firm’s worry value will increase (other things equal) 1. The size of the max probable loss increase 2. The probability of the max possible loss increases 3. The variability (control tendency) in losses increase 4. The financial strength of the firm or individual decreases

5. The level of confidence is the estimate of P* decreases 6. The level of insurance leverage decreases (as insurance becomes “less complete”) TOPIC 8 How insurance companies stay in business 1. If one person keeps risk or transfers to insurance company, there is not reduction of risk 2. If we change it to two people with the same probability of loss, then it changes a. Adding another person, expected loss goes to 2 dollars a) However, the coefficient of variance drops to .71 instead of 1 b) Insurance company will have less risk b. Every new person with HOMOGENOUS risk will reduce the risk (law of large numbers) c. This allows the risk transfer to exist and be of economic benefit d. In Heterogeneous Risk pools people paying extra will leave e. PMax is the most a person is willing to pay (WC+expected loss) Insurance is a device that:  Pools exposure to loss of individuals into a group  Uses funds paid by members of group to pay for losses as they occer.  AKA Risk sharing arrangement

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What is the commodity being purchases?  Certainty, peace of mind, safety, security, enhances credit worthiness Individual Risk still exists  Risk transfer from the insured to the insurer. Transfer the financial responsibility for payment of a loss to the insurer. Insurer agrees to indemnify the insured in the event of a cover loss.  Indemnify is to compensate or make “whole”  FULLY INDEMNIFY - place the insured in the same position financially after the loss as they were in prior to the loss o Insurance does not FULLY indemnify because then people wouldn’t care about losses o That’s why we have deductible with stuff like insurance o The Moral Hazard would go up without deductibles Three forms of Indemnification  CASH – pay money or reimbursement o Pay money after the loss  Loss settlement rules – in the contract used to determine the amount of the loss (actual cash value, replacement cost, bluebook)  Pay money after loss occurs but the amount of loss is determined in advance. Items difficult to value at the time of the  Repair or Replace (smartphone)

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Provide services as a way to indemnify o Liability insurance – provide legal services rather than reimbursing the cost of an attorney

ACCT VS RMI  Actual cash Value= replacement cost – depreciation based on replacement cost  ACCT o FMV is $100,000 o Useful like is 10 years with straight line depreciation o Book value= 100,000-30,000= 70,000  RMI o FMV is 100,000 o Replacement cost of new building= 200,000 o Useful like is 10 years o Actual cash value at the end of year three is calculated  ACV= 200,000-3(20,000) = 140,000 TOPIC 9 – Requirement of insurable risk 1) Supply of insurance a) Insurer are willing to sell insurance at a stated price b) Price on insurance= expected loss + Risk charge + admin. Costs 2) Demand for insurance a) Individuals must be willing to buy insurance at the stated price b) PMAX = WC + P* 3) Risk is insurable if Price of insurance > PMAX 4) Why might Price of insurance > PMAX? a) Individual underestimate the frequency or severity of the loss b) Moral Hazard created by disaster relief “charity relief” c) Price of insurance is “too High” i) Consumer’s view insurer’s expected loss to be too high (but it is facts from past data) ii) Insurers have a high risk charge iii) Administrative costs are too high SPECIFIC REQUIREMENTS FOR INSURABLE RISK 1. Los must be a matter of chance (fortuitous) a. Random, accidental b. Insured should have no control over frequency or severity of loss c. Violation of this is a moral hazard (arson) i. This will cause prices to go up, results in people without insurance eventually d. Solutions to Moral hazard i. Deductible and co-pays

ii. Claims investigations (prevent fraud – police report) e. Underwriting (insurance’s job is to act as a gate keeper) i. Classify into homogenous risk pools ii. Avoid adverse selection (the “bad” apples) 2. Loss should NOT be catastrophic to insurer a. Could still be catastrophic to an individual b. Minimize catastrophic losses where a single event causes multiple losses to occur at the same time (flood) c. Catastrophic losses are not independent of each other – goal of avoiding correlated losses i. Underwriters only allow so many contacts in a certain zip code d. Why are Catastrophic losses a problem? i. Risk of insolvency of insurer ii. Risk charge increases e. Solutions to catastrophic losses i. Diversify geographically ii. Diversify financially through reinsurance (insurance for insurance) 3. Loss should be definite and determinable a. Definite – easy to verify a loss occurred (property damage, fire, death) i. Difficult to verify (soft tissue injury such as back pain) b. Determinable – easy to place a dollar value on the loss i. Challenge with items such as fine arts, family belongings and pets c. Why are these two important? i. Problems with settlement are decreased ii. Otherwise it would be difficult to determine expected loss iii. Risk charge would increases iv. The price of insurance would be great PMAX 4. Loss should be significant to the insurer a. Should have relatively high severity b. Example: 6 color pen, premium would be higher than the loss itself due to administrative costs Risk Pool should be large and homogenous  Large Numbers result in a more accurate expected loss o Results In less risk charge and decrease in price of insurance  Homogenous risk pools should have similar risk o Some factors in risk pools are location, gender, miles driven and age I.

What prevents insurer’s from using “risk based pricing a. Insured may not give correct info ( they may leave out all the facts for their self interest i. Example: have you ever smoked? b. Rates may be regulated i. Genetic testing not permitted – violate social equity

ii. Community rating for health insurance – everyone in the community is charged the same premium (no penalty for high risk but no incentive for low risk people) 1. Community rating seems “fair” but results in adverse selection – higher risk stays and low risk drops out) c. Affordable Care Act – individual market i. Pre ACA: 5-1 rating bonds (low risk 4k and high risk 20k premium) ii. Post ACA: 3-1 rating bonds (low risk 6k and high risk 18k premium) 1. Young people have increased premium 2. Older people decreased premium 3. Less range of rating pool options 4. Regulations shifter many homogenous rating pools 5. Increased adverse selection 6. Adverse selection is before you purchase insurance while Morale is after Controlling Adverse Selection 1) Insurer gains more information – better underwriting overtime a) Decline in bad risk 2) Underwriting control though policy terms and conditions. Coverage can be void for misrepresentation a) Principle of utmost good faith – party obtaining insurance is held to a higher standard of honesty than typically b) Application – no smoking, sprinkler system, and where did you park your car 3) Compulsory insurance from a monopoly insurer a) Social Security: strong mandate, if you work, your employer deducts taxes from payroll (you do not have a choice) b) Medical ACA: weak mandate, enforced by IRS for individuals who do NOT purchase health/ medical insurance i) 2014 – only $95 ii) 2017 - $695 iii) 2018 – zero (tax reform act) c) Impact if individual health costs $6,500 i) Individuals with high subjective risk – already buy ii) Individuals with low subjective risk – won’t buy iii) Individuals with moderate subjective risk – some change REFER TO HANDOUTS IN CLASS FOR TOPICS 8 AND 9...