RMI 2101 Exam 2 Notes PDF

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McCloskey Chapter 4-6 Notes...

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RMI 2101 Exam 2 Notes Chapter 4 

Measurement and Evaluation of Exposures to Loss: o Step 2 in the RM Process o Measure: 

Frequency – Probability of Loss



Severity – $ Amount of Losses that Occur



Frequency & Severity – Total $ of Losses in a Given Time Period 

I. E. Expected Losses

o Risk:





Uncertainty



Variation of Expected Losses vs Actual Losses

Probability: o Measure the Event Likelihood in Advance (Odds/Chances) o Ranges from 0 to 1 

1 = Certain



0 = Impossible

o EXAMPLE ( FOR FUTURE PROBLEMS ) o A Firm Makes 2 Shipments a Month, Shipment A and Shipment B 

Same Method of Transit



Work Independently of One Another



Each Shipment Value = $100



Some Shipments are Lost / Stolen





From Past Info – 20% Chance of Loss



Probability is $100 ● 20% = 0.2

Compound / Joint Outcomes: o What is the Probability for A and B to Not Arrive (Previous EX) o

P [ A∧B ]=0.2 ●0.2=0.04

o “AND” means MULTIPLY 

2 Events that are Mutually Exclusive o Cannot Occur at the Same Time o EX:

P [ B Arrives∨Does Not Arrive]=1

o EX:

P [ B Arrives] +P [ B does not Arrive ]=0.8+0.2=1

o “OR” means ADD o Property of Mutually Exclusive Events





If ME Events are Present, Counted and Identified All Outcomes



All Outcomes = 1

Priori Probability: o Probability can be Deduced in Advance 

EX: Coin Flip, Rolling Dice

o Assumption 

All outcomes are known



All outcomes are mutually exclusive



All outcomes are equally likely

o Can a 40 Year Old Woman Use Priori to See if She Will Die? 

Outcomes Known – Yes





Mutually Exclusive – Yes



Equally Likely – No

Statistical Probability: o Make Estimates Based on Data (Stats) o Look at Past Data or Use Results from Collected Data



Law of Large Numbers: o Ober Time, the More Data You Collect / More Observations You Make, the More Accurate Your Results will Be



Random Variables: o Outcome Depends on Same Chance Event o Events are Random 

EX: Rolling Dice 



Outcomes 1–6

EX: Coin Flip 

Outcome Heads or Tails

o EX: Fate of Shipment A is Random Variable





Whether Arrives or Doesn’t Arrive



Uncertainty of Arrival and Losses are in $ Amounts

Probability Distribution: o Table / Graph that Indicates for Each Possible Outcome of a Random Variable, the Probability of Obtaining that Particular Outcome o Random Variable Yields Probability Distribution o EX: Probability Losses for Shipment A

Outcome

Probability

$0

0.8

$100

0.2

o EX: Firm Sends Out 2 Shipments per Time Period 

We Will Derive Prob. Dist. For Total Losses per Time Period



Possible Outcomes for $ Losses – $200, $100, $0



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

Alamo’s Risk: o Actual Total Losses will Exceed Their Estimate of Losses 

Drain on a Firms Capital

o To Address this Risk 

Increase Sample Size to Make More Accurate Estimate of Losses



Set Aside More than Expected Total Losses



--------



Exposure Unit: o Item, Person, or Thing of Value Exposed to Loss o EX: Property, Driver, Life, Reputation of Firm



-------



Gross Premium=Pure Premium+Risk Charge+ Administrative Cost

Pure Premium: o Amount or Portion of the Gross Premium which is Calculated as Being Sufficient to Pay for Losses Only (P*)

o P* Must be Estimated in Advance o P* Estimate May be Wrong o Actual Losses May Not be Equal to Expected Losses 

AL = EL – “Break Even”



AL < EL – “Profit”



AL > EL – “Loss”

o Insurers Face an Additional Risk  

Estimation or Parameter Risk

Risk Charge: o Reflects and Estimation of Risk of the Insurer 

Extra Amount Charged by the Insurer to Represent the Estimation Risk

o What Influences the Size / Magnitude of Risk Charge? 

Accuracy of Estimate of P*



Level of Confidence in Estimate of P*

o Insurers Use Past Information to Predict the Future (Estimate of P*) o *High Confidence means Low Risk Charge* 

Collecting Past Info: o Very Confident in P* Estimates o Little Estimation Risks o Very Low Need for a Risk Change o EX: Auto, Homeowners, Most Property Risks, Life Insurance (Mortality Rates)



Not a Lot of Past Info: o Lots of Estimation Risk

o High Need for Risk Charge o P* is an “Educated Guess” 

Lloyds of London



Surplus Lines Market

o EX: Terrorism, Olympics, “Event Risk”, Space Shuttle, J-Lo, Tom Brady 

The Middle: o Some Estimation Risk is Present o Intermediate Need for Risk Charge o EX: Natural Disasters, Floods, Certain Types of Liability Risk



--------Chapter 5



Evaluate Your Alternatives to Manage the Risk You or Your Firm Faces o Step 3 of the RM Process



Options: o Activities that Attempt to Control the Risk 

Reduce Severity / Severity of Loss

o Improve Predictability of the Loss





Less Variable



Objective Risk Falls as a Result



Decrease Coefficient of Variation

1) Loss Prevention: o Attempts to Reduce the Frequency / Probability of the Loss o Does Not Completely Eliminate it

o May or May Not Impact Severity 

Goal is to Impact Frequency

o May or May Not Impact Severity o Activities that Attempts to Interrupt or Break the Chain of Events that Lead to a Loss o Takes Place Prior to a Loss o EX: Training Program, Safety Inspection, Quality Control Checks, Security Guards 

2) Loss Reduction: o Assume a Loss Has or Will Occur o What Can be Done Prior to or After a Loss to Lessen Severity o Pre-Loss, Loss Reduction Activities 

EX: Sprinklers, Fire Exits, Fire Drills

o Post-Loss, Loss Reduction Activities 

EX: Salvage Operations, Legal Defenses, Crisis Management, Rehab of an Injured Worker



3) Separation of Exposure Units: o Break Items or Activities / Assets / Responsibilities Down Into Smaller Parts & Separating Them 

EX: One Delivery Truck vs. Two Delivery Trucks



EX: Two Suppliers of Raw Material / Cross Training or Job Sharing

o Limit Size of Loss from Any One Occurrence o Works Well to Reduce Net Income Loss Exposures

o Lowers Coefficient of Variation o Cost May be in Terms of Cost of Multiple Exposure Units and the Costs / Losses to these Multiple Units 

4) Duplication of Exposure Units: o Key Asset or Activity is Replicated and Held in Reserve 

EX: Spare Parts, Back Up Data, Copies of Records

o Critical that Replicate is Kept in Reserve – NOT IN USE 

5) Avoidance: o Not Engaging in a Risky Activity 

Reactive – Stop Engaging in Activity that Causes Loss



Proactive – Never engage in the Risk that Causes Loss

o Risk Reduced to 0 if Implemented Properly 

EX: Won’t Fly on an Airplane (No Risk of Crashing)

o Avoidance is Mutually Exclusive with All other Activities o Problems: 

Some Risks Cannot be Avoided 



Avoidance May Not Be Feasible or Desirable 





EX: Death, Weather, Natural Disasters

Lose Profits Associated with Activity (Opportunity Cost)

Legacy Cost: 

May Avoid Future Losses by Avoidance



Might not Avoid Costs from the Past

Trade One Risk for Another



EX: Travel on Plane vs Auto

o When is Avoidance Good? 

Usually High Frequency, High Severity Claims



Conduct a Cost-Benefit Analysis



Recall the “Cost of Risk” 



When “Cost of Risk” > Benefit (Profit) from an Activity

EX: Risk of Drunk Driving 

The Possibility of an Extreme Negative (Murder, Death) far Outweigh the Positive (No Uber, Save Time)



Risk Transfer of Control Type: o Shift the Activity or Asset Exposed to Loss to a Third Party o Also Shifts the Loss Exposure 

EX: Sale of a Building, Sell a Dangerous Product Line

o Loss Exposure Cannot Return to You Chapter 6 

Risk Financing Options o Deals with sources of funds to pay for those losses o External or Internal Funds



Risk Transfer of the Financing Type o Seek external resources from third parties to finance loss o Still have the asset or activity exposed to loss o Transfer the financial responsibility for the loss, not the asset or activity itself



Insurance

o Transfer the financial responsibility of the loss to the insurer but not the asset or activity itself 

Non Insurance Risk Transfers of the Financing Type o Leases 

Tenant is responsible for all property losses while occupying the property



If the tenant fails in this responsibility, the owner is ultimately responsible for the losses

o Hold Harmless Agreement 

Someone contractually accepts risk for you 



EX: Contractors doing project

Retention o A firm or individual assumes all financial responsibility for losses that do occur o Funded: 

Funds are set aside each period to deal with losses

o Unfunded: 

No separate funds to pay for the losses

o Better for Low frequency and severity 

Active vs Passive Retention o Active Retention 

Deliberate decision

o Passive Retention 

Possibly Unaware of loss



Usually failure to identify



Self Insurance o Planned active/funded retention o Usually significant loss exposures where many exposures exist o Formal program / not something that happens overnight / well thought out strategy o Ideal Characteristics 

Fairly predictable 



Medical plan for employee

Long payout period 

Workers compensation

o Advantages 

Flexibility 

Most insurance contracts are very standardized



Avoid state mandated benefit laws o Insurance requires a risk transfer to be legally liable





No Loading 

Premium = P* + Risk Charge + Admin Costs



No Premium taxes / admin costs / marketing expenses

Time Value of Money 

Any credits are invested internally which probably produce a higher rate



Saving from any loss prevention/reduction goes directly into your pocket instead of to insurance company

o Disadvantages: 

Catastrophic Loss Probability 

One large loss could wipe you out



Can handle with stop loss insurance, but need to pay premium o Insurance contract with very large deductible o Specific or individual limits on one claim 

Say $50,000 for one persons medical bills

o Aggregate is a total amount limit  

Say when all losses total over $1 million

Firm May have to perform administrative functions 

Claims settlement, return to work program, wellness program



Can resolve with an ASO (administrative Services only) contract with insurer







Can hire a TPA (third party administrator) to handle these functions



BUT ALL 3 COST MONEY

Can be a PR Nightmare 

Could give the impression that a company is financially unstable



Cant “pass the blame” to the insurer when denying claims

Hard to return to insurance market once you leave 

“Why would you come back?”



What reasons would a company that’s self funded would want to return



Income tax Treatment



Insurance o Premiums are tax deductible in tax year they are paid o Cost of doing business = premium o Premium represents cost of losses that have yet to occur o Allows a firm to prededuct the cost of future losses o Self insurance is not tax favorable o Losses and administration expenses are tax deductible – Only when paid! o Not when first known o All other things equal, tax code biases a firms decision towards buying insurance vs self funding



Captives 

Hard markets occur where cost of insurance raises tremendously o Ex: 911 terrorism coverage



Certain coverage have increasing costs o Ex: medical malpractice





Captives were formed to handle all of this



Captives also help income tax issue when self funding

Captive insurer 

Wholly owned subsidiary of a company (parent not in insurance business) o Primary purpose is to insure the risks of the parents company

o Parents purpose is to provide capital to start captive 

2 types o Single parent captive 

1 owner

o Association / group captive  

2+ owners

Captive insurer advantages 

Help during hard markets



Often located in Burma or the Caymen Islands, giving regulatory and income tax advantages



Tax treatment in the US o Can write off premium if it is a true risk transfer o True risk transfer = parent makes up no more than 30% of risk portfolio



REASONS o Help to save money on premium (usually because of a hard market) o Freedom (to cover or to do whatever you want) o Tax reasons

 

Can be a PR Nightmare

 o To see what is cheaper, compare worry values and total cost

o How does a worry value increase? 

Variability of losses increase



Level of confidence in the espimate of P*



Size of Maximum possible loss increases



Probability of the maximum possible loss increases



Financial strength of the firm / individual increases (Have $)



Level of insurance coverage decreases (assuming all other things equal)...