(CH1) Understand the concept of risk, both definition and real life examples. What is chanceof loss?
- Uncertainty concerning the occurrence of a loss
- Possibility of a loss
- Probability or magnitude of a loss is uncertain
Real life examples: the risk of being killed in an auto accident is present because uncertainty is present OR the risk of lung cancer for smokers is resent because uncertainty is present
(CH1) What is “objective risk”?
Defined as the relative variation of actual loss from expected loss
For example, Suppose there are 1000 people like you, then during a 5 year period, they are expected to have 1000 accidents, but they may actually have, say, 800 or 1200 accidents.
(CH1) Understand Law of Large Numbers and its implication in the context of objective riskand insurance.
Law of Large Number: states that as the number of exposure units increase, the more closely the actual loss experience will approach the expected loss experience
Objective risk declines as the number of exposures increases > the more exposures you have, the closer actual outcome is to the expected outcome
(CH1) What is “peril”? What is “hazard”? What are some common examples?
Peril: The cause of loss (ie. if your house burns because of a fire, the peril, or cause of loss is the fire)
Hazard: A condition that creates or increases the chance of loss
(CH1) What is “moral hazard”? Why does it matter? How to manage it?
- A loose definition: Action(s) or lack of action(s) that increase the frequency or severity of loss
- Dishonesty or character defects in an individual that increase the frequency or secerity of loss
- Why does it matter?
- 1) Increase the cost of loss for the insurer
- 2) Increase the cost of insurance for everyone
- 3) Deadweight loss
Example: Murdering the insured to collect the life insurance proceeds (difficult to manage)
(CH1) What is “pure risk”? What is “speculative risk”? What are some common examples?
Pure Risk: Only the possibilities of loss or no loss (ie. catastrophic medical expenses, flood, earthquake, premature death)
Speculative Risk: A situation in which either profit or loss is possible (ie. Gambling, Stock market investment, Running a business)
(CH1) Identify basic personal risks and risks for a firm.
- Personal Risk:
- Premature death (the death of a family head with unfulfilled financial obligations)
- Health problems
- Firm's Risk
- Physical (hazard) risk
- Financial risk
- Operational risk
- Strategic risk (ie. Competition, Market dynamics, reputation)
(CH1) What are the basic risk management methods?
- Loss control
- Noninsurnace transfers (risk is transferred to a party other than insurance company like to incorporation of a business firm)
(CH 2) What is “insurance” and what are basic characteristics of insurance?
Insurance: Insurance is the pooling of fortuitous losses by transfer of such risks to insurers, who agree to indemnify insureds for such losses, to provide other pecuniary benefits on their occurrence, or to render services connected with the risk
- Pooling of losses (Sharing of losses by the entire group)
- Payment of fortuitous losses (Unforeseen, unexpected, and occur as a result of chance)
- Risk transfer: Insured to Insurer
- Indemnification (Restore the financial position prior to the loss, no financial gain!)
(CH 2) How to calculate expected loss? What does it mean?
(CH 2) How does risk pooling work? What about correlated risks?
Pooling is the spreading of losses incurred by the few over the entire group, so that in the process, average loss is substituated for actual loss. Primary purpose of pooling is to reduce the variation in possible outcomes by standard deviation which reduces risk
(CH 2) What are the requirements for an insurable risk? Why do we need these requirements?
- Large number of exposure units (to predict average loss, to reduce objective risk)
- Accidental and unintentional loss (to control moral hazard, to assure randomness)
- Determinable and measurable loss (Insurer must be able to determine if the loss is covered and the amount of loss)
- No catastrophic loss (to allow the pooling technique to work, Approaches to manage catastrophic risks)
- Calculable chance of loss (to establish an adequate premium)
- Economically feasible premium (Affordable to consumers, Premium must be substantially less than the face value of the policy)
(CH 2) What is “adverse selection”? What are the consequences? How to manage it?
The tendency of a person with a higher-than-average chance of loss to seek insurance at standard rate if not controled by underwriting
- How to control adverse selection and/or moral hazard?
- Underwriting: selection and classification of applicants for insurance
- Pricing: based on risks (expected cost of loss)
- Policy provisions: deductibles and coinsurance
(CH 2) Identify basic types of private insurance and government insurance.
- Private Insurance
- Life and health insurance
- Property and liability insurnace
- Government Insurance
- Social insurance
- Other government insurance
(CH 2) What are social benefits and costs of insurance?
- Less worry and fear
- Investment funds
- Loss prevention
- Credit enhancement
- Insurance fraud
- Moral hazard
(CH 3) What is “risk management”?
is a process that identifies loss exposures faced by an organization and selects the most appropriate techniques for treating such exposures
(CH 3) What are (pre-loss and post-loss) objectives of risk management?
- Pre-loss (before loss occurs)
- Economical way (the firm should prepare for potential losses inthe most economical way)
- Reduce anxiety
- Meet legal obligations (ie. Government regulations may require a firm to install safety devices to protect workers from harm, to dispose to hazardous waste materials properly and to label consumer products appropriately)
- Post-loss (after loss occurs)
- Ensure survival
- Continue operations
- Stabilize earnings
- Maintain growth
- Social responsibility
(CH 3) What are the basic steps of a risk management process?
- Identify potential losses
- Evaluate potential losses
- Select appropriate risk management techniques (Risk control & Risk financing)
- Implement and monitor the risk management program
(CH 3) How to analyze loss exposures?
- Basic description
- Frequency (number of losses)
- Likelihood (How likely each outcome is to occur)
- Relative frequency of occurrence (number of losses in a given period)
- Severity (size of losses)
- Financial consequences of uncertainty
- Magnitude of loss per occurrence
(CH 3) What is “risk control”? What is “risk financing”?
Risk control: reduce loss frequency or severity (Avoidance; Loss control; Loss reduction)
Risk financing: provide funding for losses (Retention; Noninsurance Transfer; Insurance)
(CH 3) What are the basic risk control and risk financing methods? Understand them.
(CH 3) What is “captive insurer”? What is “self insurance”?
Captive insurer: An insurer owned by parent firm for the purpose of insuring the parent firms loss exposures
Self-insurance: A special form of planned retention by which part or all of given loss exposure is retained by the firm
(CH 3) What is “hold-harmless clause”?
(CH 3) What does a “risk map” describe? How is that used?
Risk map: are grids detailling the potential frequency and severity of risks faced by the organization.
Use of risk maps varies from simply graphing the exposures to employing simulation analysis to estimate likely loss scenarios
(CH 3) How to manage personal risks?
Avoidance, risk control, retention, noninsurance transfer, insurance
(CH 4) What are the basic methods for forecasting losses?
- Analyze frequency and severity of loss exposures
- Rely on historical data (Probability analysis & Regression analysis)
- Forecasting based on frequency or severity loss distribution
Other advanced methods
- Analyze total lossCombine frequency and severity
- Normal approximation (use mean and SD to characterize)
- Computer simulations
(CH 4) What is “time value of money”? What is NPV of a project? How does that apply torisk management decisions?
Time value of money: means that when valuing cash flows in different time periods, the interest-earning capacity of money must be taken into consideration
NVP (Net Present Value) of a project is the sum of the present values of the future net cash flows minus the cost of the project
(CH 4) What are common types of financial risks? How are they different from pure risk exposures (e.g., property and liability risks)?
- Market Risk
- Credit Risk
- Operational Risk
(CH 4) What is “Value-at-Risk (VaR)”? Understand it. What is it used for? How is it related to“maximum probable loss”?
- VaR is the worst probable loss likely to occur in a given time period under regular market conditions at some level of confidence
- Maximum dollar loss for a portfolio (or a firm), with a given probability, for a given holding period
- Based on VaR estimate, the risk level could be could be increased or decreased depending on risk tolerance
- The concept is often applied to a portfolio of assets such as a mutual fund or a pension fund and is similar to the concept of "maximum probable loss" in traditional property and liability risk management
(CH 4) What are common types of financial derivatives?
(CH 4) What are some differences between insurance and derivative contracts?
- Derivative contracts
- Based on underlying assets
- Usually involves two parties for transaction
- The two parties may have opposite loss exposures
(CH 4) What is “catastrophic risk”? What are some examples? How to manage it?
Natural disasters; “Man-made” disasters
- How to manage
- Use insurance
- Government-sponsored reinsurance
- Via capital market
(CH 4) What is “securitization”? How does it work?
insurable risk is transferred to the capital markets through creation of a financial instrument, such as a catastrophe bond, futures contracts, options contract, or other financial instrument
(CH 5) What is stock insurer and what is mutual insurer? How are they different? What is“demutualization”? Why demutualize?
- Stock insurer: is a corporation owned by stockholders. The objective is to earn profits for the stockholders. Dividends pay stockholders
- Mutual insurer: is a corporation owned by the policyowners. There is no stock holders. The policy owners elect a board of directors. Dividends pay to policyowners
- Demutualization: means that a mutual insurer is converted into a stock insurer
- Reason to demutualize: raise new capital, stock insurers have greater flexability, tax advantage
(CH 5) What is “Lloyd’s of London”?
Not an insurer, but is the world's leading insurance market that provides services and physical facilities for its members to write specialized lines of insurance
(CH 5) What is insurance “agent”? What is insurance “broker”?
- An agent is someone who legally represents the principal and has the authority to act on the principal's behalf
- A broker is someone who legally represents the insured
(CH 5) What is a “binder”?
a temporary insurance until the policy is actually written
(CH 5) What is “surplus lines broker”? What is “nonadmitted insurer”?
- Surplus lines broker: a special type of broker who is licensed to place business with a nonadmitted insured
- Nonadmitted insurer: is an insurer not licensed to do business with a nonadmitted insurer
(CH 5) What are different types of life insurance marketing systems?
- Agency building system
- Nonbuilding agency system
- Direct response system
(CH 5) What are different types of property and casualty insurance marketing systems?
- Independent agency system
- Exclusive agency system
- Direct writer
- Direct response system
- Multiple distribution system
(CH 6) What is “rating making”?
refers to the pricing of insurance and the calcuation of insurance premiums
(CH 6) What is “underwriting”? Objectives of underwriting? What are the sources for underwriting information? What are the basic underwriting principles? What do they mean? Why do we need these principles?
the process of selecting, classifiying, and pricing applicants for insurance
- Select applications in order to make profits
- Control moral hazard and adverse selection
- Sources of underwriting information
- Agent’s report
- Physical inspection
- Physical examination
- MIB report
- Attain an underwriting profit
- Select prospective insured according to the company’s underwriting standards
- Provide equity among the policy owner
(CH 6) Understand the claims settlement process.
- Claims settlement process
- Notice of loss must be given
- The claim is investigated
- A proof of loss may be required
- A decision is made concerning payment
- Objectives of claims settlement
- Verification of a covered loss
- Fair and prompt payment of claims
- Personal assistance to the insured
(CH 6) Why do insurance companies invest and what do they invest in? What are thedifferences between investment activities in life insurers and in property/casualty insurers?Why do these differences exist?
- Why do insurance companies invest?: To generate income; Especially important when rate competition is intense
- Invest in: Life insurance investment; Property and Casualty Insurance investment
- Difference: Life insurance is long-term and P&C is short-term
(CH 6) What is reinsurance? Know the different terms used in reinsurance. Why do insurance companies reinsure? Understand these reasons.
- an arrangement by which the primary insurer that initially writes the insurance transfers to another insurer part or all of the potential losses associated with such insurance
- Reinsurance is the purchase of insurance by an insurer
- Reason for reinsurance
- Increase underwriting capacity
- Stabilize profits
- Reduce the unearned premium reserve
- Provide protection agains a catastrophic loss
The primary insurer that initially writes the business is called the ceding company
. The insurer that accepts part or all of the insurance from the ceding company is called the reinsurer
. The amount of insurance retained by the ceding company for its own account is called the retention limit
or net retention
. The amount of the insurance ceded to the reinsurer is known as a cession
. Finally the reinsurer in turn may reinsure part of all of the risk with another insurer. This is known as a retrocession
. In this case the second reinsurer is called retrocessionaire
(CH 6) What are different types of reinsurance (e.g., facultative reinsurance, treaty reinsurance,quota-share treaty, surplus-share treaty, excess-of-loss treaty, reinsurance pool)? Howdoes each type of reinsurance work?
(CH 6) What are alternative risk management methods to reinsurance (e.g., securitization, ormore specially, catastrophic bond)?
(CH 7) What is “policyholders’ surplus”?
- the difference between an insurance company's assets and liabilities
- Surplus can be thought of as a cushion that can be drawn upon if liabilities are higher than expected
- If the insurer were to pay all of its liabilities using its assets, the amount remaining would be policyholders’ surplus
(CH 7) What are the business and regulatory objectives in rate making?
- Regulatory objectives
- Not excessive
- Not unfairly discriminatory
- Reasonable (life insurance)
- Business objectives
- Encouragement of loss control
(CH 7) What are the basic components of insurance price (or “rate”)? How to calculateinsurance rate?
- Rate: price per unit of insurance
- Exposure unit: unit of measurement varies by lines (e.g., one car-year for auto insurance)
- Pure premium: expected claim cost (covered losses and loss adjustment expenses)
- Loading: amount added for other expenses, profit and contingencies
- Gross rate: pure premium plus loading
- Gross premium: gross rate * # of exposure units
- EX: Auto insurance
- Exposure: 1 car-year
- Pure premium: $200
- Loading: 40%
- Gross rate=$200*(1+40%)=$280
- Gross premium=$280*1=$280
(CH 7) What are the basic rate-making methods for property and casualty insurance?Understand them.
- Judgment rating: Each exposure is individually evaluated based on the judgment of the underwriter
- Class rating (manual rating): Exposures with similar characteristics are placed in the same class, and charged the same rate; Rating variables and adverse selection
- Merit rating: Class rates adjusted based on individual loss characteristics
(CH 7) What are the basic rate-making methods for life insurance? Understand them
- Mortality table: probability of death at each certain age
- Net single premium (NSP) = present value of future death benefits: Assume premium paid at the beginning of policy year, death claim paid at the end of policy year, uniform death rate throughout a year
- Level premium: insurers determines the monthly or annual premium to cover claim cost and expenses throughout the policy (mathematical equivalent of NSP)
(CH 7) What is “loss reserves” and what are the components? What role does it play?
- The estimated cost of settling claims for losses that have already occurred but that have not been paid as of the valuation date. The loss reserve is an estimated amount for (1) claims reported and adjusted but not yet paid, (2) claim reported and adjusted but not yet adjusted and (3) claims for losses incurred but not yet reported to the company
- Loss reserve is especially important to a casualty insurer because bodily injury and property damage liability claims may take a long time to settle
- Recognizes the insurer’s financial obligation to pay future claims (a liability item)
(CH 7) What is “unearned premium reserve”? What role does it play?
- A liability item that represents the unearned portion of gross premiums on all outstanding policies at the time of valuation
- An insurer is required by law to place the entire gross premium in the unearned premium reserve when he policy is first written and to place renewal premium in the same reserve
(CH 7) What is “loss ratio”? “Expense ratio”? “Combined ratio”? What do they measure?
- Loss ratio: Reflects underwriting results*
- Expense ratio: Underwriting expenses/premiums written
- Combined ratio: Overall underwriting performance**
- **Loss ratio + expense ratio
- *(Incurred losses + loss adjustment expenses)/Premiums earned
(CH 7) What is “underwriting cycle”?
- Cyclical pattern in underwriting stringency, premium levels, and profitability in P&L insurance markets
- “hard” and “soft” insurance market
- `Undesirable fluctuations in availability and price of insurance coverage
- `Must be taken into account when making risk management decisions
(CH 9) What are the general purposes of these legal principles?
Reduce contracting costs: moral hazard (MH) and adverse selection (AS)
(CH 9) What is “Principle of Indemnity”? Why is it important? What are the exceptions to thisprinciple?
The insurance policy cannot pay more than the actual amount of the loss suffered
- Prevent the insured from profiting from a loss
- Reduce moral hazard
(CH 9) How to calculate “actual cash value”? What is “actual cash value” used for?
- Definition: The basis of loss settlement that supports indemnification OR
- Value of property at the time of its damage or loss, determined by subracting depreciation of the item from its replacement cost
- How to calculate ACV: (Replacement cost) minus (depreciation)
- Used for
- Replacement cost less depreciation
- Fair Market Value: Price in a free market; may differ from replacement cost less depreciation
- Broad evidence rule: ACV determination includes all relevant factors that may be used by an expert
- ACV example
- Replacement cost minus depreciation
- This couch cost Carrie $1200 when she bought it
- After three years, the couch was totally destroyed by fire
- A similar new couch will cost $1500
- The couch is estimated to be 40% depreciated
- What is the ACV of the couch?
(CH 9) What is “Principle of Insurable Interest”? Why is it important? What is the basis ofinsurable interest for life insurance and for property & casualty insurance? When must an insurable interest exist for life insurance and for property & casualty insurance?
- Definition: The insured must suffer adverse financial consequences if a covered loss occurs
- Importance: Prevent gambling; Reduce moral hazard; Measure the amount of loss
- Basis of insurable interest for P&C
- Ownership of property
- Potential legal liability
- Secured creditors
- Contractual right
- When must an insurable interest exist
- Property: at the time of loss
- Life: at the interception of the policy, not at the time of death
(CH 9) What is “Principle of Subrogation”? Why is it important?
Allows the insurer to recover loss payments made to an insured from a third party
- Prevent the insured from collecting payments twice
- Hold the negligent person responsible for the loss
- Hold down insurance rates
- Example: Assume that a negligent motorist fails to stop at a red light and mashes into Megan’s car, causing damage in the amount of $5000. If she has collision insurance on her car, her insurer will pay the physical damage loss to the car (less any deductible) and then attempt to collect from the negligent motorist who cause the accident. Alternatively, Megan could attempt to collect directly from the negligent motorist for the damage to her car. Subrogation does not apply unless the insurer makes a loss payment
(CH 9) What is “Principle of Utmost Good Faith”? What is a representation? What is the legal significance of a representation?
A higher degree of honesty is imposed on both parties to an insurance contract
- RepresentationsAlso applies to statements made after a loss
- Statements made by the insurance applicant
- Insurance contract is voidable if representation is Material; False; Relied on by the insurer (or “misrepresentation”)
(CH 10) What is “deductible”? Why is deductible used in an insurance contract? Understand basic types of deductibles.
a provision which eliminates coverage for small losses
- Reduce claims processing cost and premium
- Reduce moral hazard (Incentive for loss control)
- Reduce adverse selection (Separation of high risks and low risks)
- Types of deductibles
- Straight vs. aggregate deductible (property insurance)
- Elimination period (health insurance)
(CH 10) What is “coinsurance”? What is a coinsurance clause in health insurance? What is acoinsurance clause in property insurance?
- Coinsurance is a contractual provision that often appears in property insurance contracts. This is especially true of commercial property insurance contracts
- Coinsurance clause in property insurance: The percentage of the property’s value that the insured is required to purchase insurance for in order to receive full reimbursement of a loss
- Example: A building valued at $100,000 is insured for $50,000. The coinsurance percentage is 80%. The loss incurred is $30,000. The loss paid is [$50,000/($100,000*80%)]* $30,000=$18,750
- Purpose: Make sure premiums are fair for both partial coverage and full coverage
- Coinsurance in health insurance: Requires an insured to pay a proportion of the covered loss
- Purpose: Reduce moral hazard and adverse selection
- Examples: Office visit co-pays; Co-pay for surgeries
(CH 10) Understand the basic types of other-insurance provisions (Note that some applications will be seen in specific lines of insurance, e.g., automobile insurance policies)
- Used when multiple policies cover the same loss
- Pro rata liability
- Contributed by equal shares
- Primary and excess insurance
- E.g., auto insurance
Understand risk aversion and its implication for individual insurance demand.
Understand risk premium.
- Risk premium (assume risk averse)
- E.g. you will accept a 60%(win) vs. 40%(lost) bet E(M)=$5,000*0.6+(-$5,000)*0.4=$1,000>$0
- The extra $1,000 you require is "risk premium”
- In other words, you are willing to pay more than expected loss to eliminate risk (e.g., Mr. RA $89,000 vs. [$80,000 and $100,000])
What are other factors that affect individual demand for insurance?
- Premium loaadings: Higher premium loadings, lower insurance demand
- Wealth and income: Do rich people need more insurance?
- Information: Risk perception
- Other sorces of indemity
- Nonmonetary losses
Understand the argument that shareholder diversification is an alternative to corporateinsurance contracts (understand the basic idea; for reference, see Harrington & Niehaus Chapter 9).
What are the additional benefits that insurance may provide to diversified shareholders?
- Additional benefits of insurance
- Insurance services
- Reduce loss financing costs
- Reduce cost of financial distress (New investment opportunities; Contract terms)
- Progressive tax rates