Principles of Risk Management and Insurance.ppt

Risk Management

Hurricane Katrina: Landfall August 29, 2005

1

Fair Bet • Cost Equals Expected Gain • Cost = P * (Amount you Win) • Example: Flipping a Coin – Cost = $10 – P = .5 – Amount You Win = $20

2

Is This A Fair Bet? • Flipping A Coin – Cost = $50 – Amount You Win = $75

3

Risk Taking Behavior • Risk-Averse • Risk-Neutral • Risk-Taker (Risk-Seeker, Risk-Lover)

4

Risk and Uncertainty • Risk: A situation in which several different outcomes are possible. • Uncertainty: The perception that several different outcomes are possible. 5

Categorizing Risk • Pure Risk v. Speculative Risk • Diversifiable Risk v. Nondiversifiable Risk • Fundamental Risks and Particular Risks

6

Pure Risks v. Speculative Risks • Speculative Risks are Usually Chosen – Stock Appreciation – Manufacturing and Selling a Product – Example: Furby • Pure Risks are Usually a Byproduct – Automobile Accident – Sports Injury 7

Diversification • Pooling Similar Risks – INSURANCE

• Pooling Offsetting Risks – A DIVERSIFIED PORTFOLIO

8

Why Reduce Uncertainty • Individual • Corporations • Government

9

Why Manage Risk? Individuals • Reduce anxiety

• Planning

10

Why Manage Risks: Corporation (Nexus of Contracts) owners creditors

employees

Corporation

suppliers

government customers

11

Early Historical Examples of Risk Management

• Chinese Trading Boats

• Amish Rebuilding

12

Modern Risk Management • Prior to 1950s: Insurance Purchaser • Risk Managers – Finance Dept., Freestanding, or Human Resource Dept. – Larger Companies – Companies Facing Greater Risk 13

Risk Manager: Minimize Adverse Consequences of Risk

• • • • •

Avoidance Loss Control Self-Insurance Purchase Insurance Anticipate Risk 14

The Decision to Manufacture a Product

15

Product Development: Motorcycle • Investment: $1,000,000 • Profits if there is no Loss: $150,000 • Possible Liability Losses: – 1% Chance of $2,000,000 Loss

• Required Return on Investment: 10% 16

Hiring an Employee

17

Hiring an Employee: Baseball Player with Drug Addiction • Salary: $200,000/year • Financial Contribution to Club – $300,000 if Says Clean – $50,000 if Uses Drugs – Chance of Staying Clean: 50%

18

Major Duties of Risk Managers • • • • • • • • •

Buy Insurance Identify Risk Loss Prevention and Loss Control Contract Review Safety Training and Education Govt. Compliance with Safety Issues Risk Finance Claims Mgmt. and Litigation Support Employee Benefits

19

Risk Management Process • • • •

Mission Identification Risk Identification Risk Analysis Consider Alternatives – Risk Control – Risk Finance

• Implement and Monitor

20

Mission Identification

• Goal of Organization • Goal of Risk Management Department

21

Organization Goals • Corporation: Maximize Profits • Non-Profit Organizations – Religious Organization – Hospitals

22

Organization Goals • Charities – Red Cross: The American Red Cross, a humanitarian organization led by volunteers, . . . will provide relief to victims of disasters and help people prevent, prepare for, and respond to emergencies.

23

Post-Loss Objectives • • • • •

Survival of the Organization Continuity of Operations Earnings Stability Continued Growth Social Responsibility 24

Pre-Loss Objectives • Economy • Reduction in Anxiety – – – – –

Owners Suppliers Lenders Customers Govt. Agencies

• Meeting Externally Imposed Obligations • Social Responsibility 25

Risk Management Process Step 2

Risk Identification and Analysis

26

Risk Identification: Key Terms • • • •

Hazard Risk Factor Peril Exposure

27

Difficulties with Risk Identification • New Laws

– Examples: Building Codes, Clean Air Act

• New Discoveries

– Examples: Black Lung, Second Hand Smoke

• Changing Societal Attitudes

– Example: Product Liability Laws, Cigarettes

28

New Laws and Risk Identification

29

Sources of Risk • • • • • • •

Physical Environment Social Environment Political Environment Legal Environment Operational Environment Economic Environment Cognitive Environment 30

Social Environment and Disney Co. • • • •

Euro-Disney “Powder” Domestic Partner Benefits History Theme Park at Manassas

31

Example • Workplace Injury

32

Categories of Exposures • Property Exposures – Direct: Immediate Result – Indirect: Secondary Results – Example: Robbery of a Store

• Liability Exposures • Human Resource Exposures

33

Risk Identification Methods 1 • • • • •

Insurance Survey Risk Analysis Questionnaires Financial Statement Analysis Flow Chart Method Systems Safety Techniques

34

Risk Identification Methods 2

• • • •

Interactions with External Resources Interactions with other Departments Past Losses On-Site Inspections

35

Accident Causation

• Human Relations View • Engineering View

36

Loss Analysis Ratios

• Severity = $Losses / # Losses • Frequency = # Losses / # Exposures

• Expected Loss = $ Losses/ # Exposures 37

Ratios Example • Data – 1000 Restaurants – 50 Fires • Type 1 Fires: 20, $25,000 • Type 2 Fires: 30, $50,000

• Severity = [20($25,000) + 30($50,000)]/50 = $40,000 • Frequency = 50 / 1000 = .05 • Expected Loss = .05($40,000) = $2000 38

Concerns with Measuring Severity • Indirect Losses – Ex: Store robbery

• Contagion – Ex: Foot-and-Mouth Disease

• Snowball Effect – Ex: Mad Cow Disease 39

Contagion Example: Bil Mar

40

Contagion Example: Listeria • Chicago-based Sara Lee recalled hot dogs and deli meats produced at its Bil Mar plant in Zeeland, Michigan, after the CDC found listeria contamination in unopened packages of the products. • Affected brand names include Ball Park, Bil Mar, Sara Lee Deli Meat and Sara Lee Home Roast. • The states reporting listeria infections are Arizona, Connecticut, Georgia, Indiana, Iowa, Kentucky, Maryland, Massachusetts, Michigan, Minnesota, New York, Ohio, Oregon, Pennsylvania, Tennessee, Vermont and West Virginia. 41

Contagion Example: Listeria • Tainted meat – Killed 12 people – Sickened 79 others in 16 states

• 241 workers fired or layed off

42

Loss Severity Measures

• Maximum Possible Loss • Maximum Probable Loss

43

Example Year

Flights

Crashes

2003 2004 2005 2006 2007

5,000 5,000 5,000 5,000 5,000

10 0 4 2 0

Losses $2,000,000 0 $1,000,000 $500,000 0

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Loss Statistics n  Oi pi i1 freq mean = .2(.002)+.2(0)+.2(.0008)+.2(.0004)+.2(0)

Mean =

= .00064 sev mean = 10 (200,000)  6 (250,000) 16 16 = $218,750 E(L) = $140

45

Loss Statistics S.D. =

Sev S.D. =

n  pi ( O i  E V i ) 2 i1

(10)(200,000  218,750)2 16 ( 6 )(250,000  218,750)2 16

= $26,791

46

Normal Distn Severity Distance 1 S.D. 2 S.D.

Prob 68.2% 95%

$218,750 $191,959 $165,168 [ [ [

$245,541 $272,332

freq = .00064 sev = $272,332 E(L)95% = $174.29 47

Calculating the Mean and Std. Dev. Number of Fires

Probability

0 10 30 50 60

.10 .20 .40 .20 .10

mean =

.10(0)+.20(10)+.40(30)+.20(50)+.10(60) = 30

S.D. =

sq. root [.10(0-30)(0-30) +.20(10-30)(10-30) +.40(30-30)(30-30) +.20(50-30)(50-30) +.10(60-30)(60-30)] = 18.43 48

Important Distributions

• Loss Frequency Distribution • Loss Severity Distribution • Total Loss Distribution

49

Loss Frequency Distn Taxi Accidents N = 2000

Ot 0/2000 10/2000 30/2000 50/2000 60/2000

Pt .10 .20 .40 .20 .10

n E(Ot )   ptOt  AvgFreq. t 1  0(.10) .005(.20) .015(.40) .025(.20) .03(.10) .015

.015(2000) = 30 Accidents 50

Loss Severity Distn N = 100

Sevt $1,000 $2,000 $10,000 $50,000

Pi .80 .05 .10 .05

n E(Sev )   (Sev )( pt ) i i1 i  $1,000(.80)  $2,000(.05)  $10,000(.10)  $50,000(.05)  $4,400 51

Drawbacks to Use of Historical Data

• CHANGE in Process

• Insufficient Data

52

Importance of Timing of Losses

• Time Value of Money

• Cash Flow Considerations

53

Loss Triangles

• Predict When Losses Will Occur • Predict Total Losses • Highlight Trends 54

Loss Triangle Product Liability Suits Loss Year Year of Experience (ex. Year of Sales)

2003 2004 2005 2006 2007

2003 12

2004 16 16

2008 = 15 x 1.337 = 20 2009 = 20 x 1.246 = 25

2005 20 21 9

2006 22 26 12 8

2007 22 29 15 11 15

2010 = 25 x 1.1075 = 28 2011 = 28 x 1 = 28 55

Development Factors

Development Period Year of Experience

2003 2004 2005 2006

y+1 1.33 1.3125 1.33 1.375

y+2 1.25 1.238 1.25

y+3 1.10 1.115

y+4 1.00

MEAN

1.337

1.246

1.1075

1.000

Examples 2003, y+1 = 16/12 = 1.33 2003, y+2 = 20/16 = 1.25 56

Loss Development: 2007 Sales Year 2007: 15 Losses

2008: 2009: 2010: 2011:

15 x 1.337 20 x 1.246 25 x 1.107 28 x 1.000

= 20 = 25 = 28 = 28

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Present Value Calculation Determining Losses from 2003 Sales Claim Made in Year 2003 2004 2005 2006 2007 2008 2009 Losses 2003 Sales

i% 6% 6% 6% 6% 6% 6% 6%

Total Cost/Claim PV in 2003 # Losses Losses $10,000 $12,000 $14,000 $15,000 $18,000 $20,000 $24,000

$10,000 $11,321 $12,460 $12,594 $14,258

12 4 4 2 0

$120,000 $45,284 $49,840 $25,188 0

$240,312

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Homework Problems

• A) Determine the Number of Fully Developed Losses for 2004, 2005, and 2006. • B) What is the PV of Losses Arising from 2005 Sales as of 2005? 59

Shapes of Different Distributions

• Medical Expenditures • Church Fires • Parking Tickets

60

Normal Distribution

• Bell Shaped • Two Parameters • Easy to Use

61

Property Losses

• Property Exposed to Loss • Peril • Financial Consequences

62

Property Exposed to Loss

[ Real Property

[ Personal Property [ Non-owned Property 63

Non-owned Property • • • • • • •

Bailed Property Leased Property Property on Consignment Employee’s Property Property under Lien Agency Relationships Contingent Property 64

Perils

• Commonly Insured

• Government Insured • Uninsurable

65

Commonly Insured Perils 1 • • • • • •

Fire Lightning Windstorm Hail Explosion Smoke 66

Commonly Insured Perils 2 • • • • • • • • • •

Aircraft & Vehicle Damage Riot Vandalism (Malicious Mischief) Falling Objects Weight of Snow, Ice, or Sleet Water Damage Glass Breakage Sprinkler Leakage Perils of Transportation Crime Perils 67

Difficult to Insure Perils

• Earth Movement

• Floods • Nuclear Reaction

68

Why Are Some Perils Uninsurable? • Against Public Policy • Under the Control of the Insured – Ex. Suicide

• Probability of Loss is Too High • Simultaneous Destruction

69

Generally Uninsurable Perils • War, Terrorism, Rebellion, and Insurrection • Intentional Losses • Fading, Rust, Dry Rot, Settling • Production, Marketing, and Political Risks 70

Financial Consequences • • • • • • • • • •

Reduction in Value Debris Removal Business Interruption Contingent Business Interruption Loss of Rental Income Loss of Rental Value Loss of Leasehold Interest Inability to Reconstruct Records Loss of Use Value in Improvements and Betterments Demolition Costs and Increased Cost of Reconstruction 71

Valuation of a Loss • Market Value • Replacement Cost • Actual Cash Value – (Replacement Cost - Depreciation) • Present Value of the Asset’s Contribution

72

Actual Cash Value Calculation: Building • Purchase – Date: January 1, 1987 – Price: $1,000,000 – Expected Lifetime: 40 years

• Fire – Date: January 1, 2007 – Replacement Cost: $2,000,000 73

Actual Cash Value Calculation: Building

• ACV = Replacement Cost - Depreciation

–As of the Time of Loss • ACV = $1,000,000 = $2,000,000 - $1,000,000

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Present Value of the Asset’s Contribution

75

Liability Loss • Expenditure of TIME and MONEY • Investigate, Negotiate, Defense, Payment

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Property Losses v. Liability Losses • Parties Involved • Measurement of Exposure • Changing Environment • Tail 77

Types of Legal Liability • Criminal – Agent – Punishments – Insurance

• Civil – Private Duties – Common Law, Statutes, Contracts 78

TORT • Wrongful Act or Omission • Independent of Contract • Legal Remedy: DAMAGES ($$$) 79

Types of TORTS

• Intentional Torts • Negligence

• Strict Liability 80

Intentional TORTS

• Legally Protected Right • Intentional Interference – Voluntary – Damages Reasonably Foreseen – No Valid Defense 81

Intentional Torts: Defamation • Types – Libel – Slander

• Plaintiff Must Show – False, Injurious Statement – Publication – Damages 82

Defenses • Truth • Privilege – Absolute – Qualified • • • • •

No Malice Not Known False No Intent to Injure Fair, if by news media Covered Body 83

Intentional Torts: Invasion of the Right of Privacy

• Examples – Release Confidential Information – Hidden Microphones

• Public Figures v. Private Figures

84

Intentional Torts: Assault and Battery

• Assault • Battery • Defenses – – – – –

Consent Self-Defense Defense of Property Defense of Others Allowed Discipline 85

The “Preppy Killer”: Consent?? 'Preppie killer' headed back to prison on drug rap NEW YORK (AP) -- New York's so-called "preppie killer" is headed back to prison. Robert Chambers already served 15 years behind bars for strangling a woman in Central Park during what he said was rough sex. He pleaded guilty Monday to selling drugs. The Manhattan district attorney's office says Chambers is promised 19 years and four months in prison when he is sentenced on September 2. Chambers and his girlfriend were charged with dealing cocaine out of their Manhattan apartment in 2007.

Chambers pleaded guilty in 1988 to manslaughter in the death of 18-year-old Jennifer Levin two years earlier. Stories portrayed him as a handsome, privileged, prep school youth gone bad. He was released from prison in 2003.

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Intentional Torts: Assorted Others • False Arrest and Wrongful Detention • Malicious Prosecution • Trespass • Conversion • Nuisance

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Intentional Torts: Assorted Others Continued • Wrongful Interference with a Business Relationship – Copyright Infringement – Deception

• Bad Faith – Delaying Payment of Claims – Refusing to Pay Claims 88

Negligence • Acts of Omission • Acts of Commission

89

Elements of a Negligent Act • Legal Duty • Breach • Damages • Proximate Cause 90

Damages • Compensatory Damages – Special Damages – General Damages

• Punitive Damages

91

Defenses to Negligence • • • • •

Contributory Negligence Comparative Negligence Assumption of Risk Statute of Limitations Immunities – Sovereign – Charitable Institutions – Public Officials 92

Strict Liability Torts • Abnormally Dangerous Instrumentalities • Ultrahazardous Activities • Dangerously Defective Products • Workers Compensation Statutes • Disability Benefit Statutes • Aviation Law • Dram Shop Laws • Contractual Assumptions 93

Goals of the Tort System

• Compensate • Deter

94

Tort Reform Proposals

• Modify Joint and Several Liability

• Caps on Non-Economic Damages • Caps on Punitive Damages

95

The Work Relationship • Employer – Sets Hours – Defines and Supervises Work

• Employee – Sacrifices Time for Income – Is Told How to Work – Method of Payment Not Important to Status

• Independent Contractor – Not an Employee – Controls Methods of Work 96

Workplace Injuries

• Common Law: Negligence • Statutory Law: Workers Compensation

97

America’s Most Dangerous Jobs in 2004

Rank

Occupation

Death rate/100,000

Total deaths

1

Logging workers

92.4

85

2

Aircraft pilots

92.4

109

3

Fishers and fishing workers

86.4

38

4

Structural iron and steel workers

47.0

31

5

Refuse and recyclable material collectors

43.2

35

6

Farmers and ranchers

37.5

307

7

Roofers

34.9

94

8

Electrical power line installers/repairers

30.0

36

9

Driver/sales workers and truck drivers

27.6

905

10

Taxi drivers and chauffeurs

24.2

67

98

Some Exceptions to Workers Compensation • Small Firms

• Farm Workers • Domestic Workers

99

Employers’ Common Law Duties • Safe Place to Work • Adequate Number of Competent Fellow Employees • Provide Safe Tools and Equipment • Warn of Inherent Dangers • Make and Enforce Safety Rules 100

Workers Compensation • Accident

• Arising Out of and In the Course of Employment • Only Bodily Injury 101

Workers Compensation Benefits • Lost Wages

• Medical Care • Body Part Payments • Death Benefits 102

Exceptions to WC as Sole Remedy for Workplace Injury • • • •

Assault by the Employer Retaliatory Discharge of the Employee Dual Capacity Doctrine Suits by 3rd Parties – Ex. Loss of Consortium – Ex. Consequential Injuries

• Property Damage 103

Human Resource Exposures

• Loss of Personnel • Cost of Employee Benefits

104

Employee Benefits • Attract Workers • Retain Workers • Retire Workers • Encourage Productivity 105

Loss of Personnel • Premature Death • Disability/Poor Health

• Resign 106

Premature Death Losses that Result • Loss of Human Life Value

• End of Life Expenses • Emotional Grief of Survivors

107

Premature Death Risk Management Strategies • Loss Prevention: – Medical Care – Good Health

• Life Insurance: Many are Underinsured • Pension Plan • Earnings of Surviving Spouse 108

Estimating Human Life Value Example: Worker 3 years from Retirement

Year

Output

Pay

2004 2005 2006

50000 49000 48000

40000 38000 36000

TOTAL

Surplus PV(8%) 10000 11000 12000

10000 10185 10288 30473

109

Calculating Loss of Human Life Value Worker dies at age 61 after being paid. At the time of death 3 working years remained. Age 62 63 64 Total

Earnings

Taxes

$40,000 $40,000 $40,000

$16,000 $16,000 $16,000

Self

Family

PV(8%)

$10,000 $14,000 $10,000 $14,000 $10,000 $14,000

$14,000 $12,963 $12,003 $38,966

110

Disability Problem • Disability is comparatively frequent • Disability can be extremely costly • Most lost income due to disability is not replaced • Disability insurance is confusing – Multiple definitions of disability

• Disability insurance is subject to moral hazard – Malingering 111

Risk of a 90+ Day Disability v. Death During Working Years

Age 22 62

P(Disability)/P(Death) 7.5 2

112

Risk Control • • • • •

Avoidance Prevention Reduction Information Management Some Risk Transfers

113

Risk Avoidance • Proactive Avoidance

• Abandonment

114

Drawbacks to Avoidance • Lost Benefits of Risk • Perhaps not Possible $ Government Imposed Risks $ Nature of the Risk

• May Result in Worse Risks

115

Important Forms of Loss Reduction    

Salvage Subrogation Litigation Management Catastrophe (or Contingency) Plans  Duplication  Separation 116

Information Management as Loss Control

• • • •

Customers: Enhanced Sales Creditors: Lower Debt Cost Suppliers: Better Relationships Owners: Greater Market Value 117

Risk Transfer • Property or Activity Transferred

• Contractually Pass the Liability “Exculpatory Contracts”

118

Government and Risk Control • Public Interest • Efficiency

119

Risk Financing: General Methods

• Retention • Transfer

120

Risk Financing: Timing • Contemporaneous

• Prospective • Retrospective 121

Approaches to Retention

 Passive or Unplanned  Active or Planned

122

Retention: Funding Arrangements • No Advance Funding • Liability or Earmarked Accounts • Earmarked Asset Accounts • Captive Insurer 123

Types of Transfers • Insurance • Noninsurance Transfers • Hedging 124

Elements of Insurance • Contract • Premium • Conditional Benefits • Pooling of Resources 125

Insurance Transaction • Buyer Side of the Market – Risk Managers – Brokers – Consultants

• Supplier Side of the Market – Insurance Company • Underwriters, Claims Adjusters, Agent, Actuaries

– Agent 126

Noninsurance Transfers

• Do Not Satisfy Conditions to be Insurance • Provide External Funding

127

Hedging • Taking an Offsetting Risk

• Not Possible for Many Types of Risks

128

129

130

131

Hedging Example

January 1: Arrange to sell chairs for $5.00 Raw materials today cost $2.50/chair June 1:

Build chairs

July 1:

Deliver chairs

132

Hedging Example

Risk:

Cost of raw materials

Options:

1. Sell chairs on a cost + basis 2. Buy and hold raw materials 3. Buy and have seller hold raw materials 4. Use a hedge 133

“Futures” Contract Owner of contract on Termination Date Receives the lumber

Price of contract depends on a) Cost of lumber today b) Risk Premium Origination Date: September 1 Termination Date: August 31.

134

Hedging Contract January 1:

June 1:

Buy Hedging Contract Hedging Contract = $2.50 + x Lumber = $2.50 Risk Premium = x Buy Lumber & Sell Futures Contract Lumber = $2.50 + y Futures Contract = $2.50 + (x - z) + y Change in lumber cost = y Depreciation of risk premium = z Total Cost = ($2.50 + x) + ($2.50 + y) - ($2.50 + (x - z) + y) = $2.50 + z 135

Hedging Contract Numerical Example Origination Date: September 1 Termination Date: August 31. Original Risk Loading: 0.60 x = .40 x decreases .05 per month z = .05(5) = .25 Total Cost = $2.50 + .25 = $2.75 136

Hedging Instruments for Financial Risks

137

Hedging Volatility

• Volatility is a measure of risk • Some sources of volatility can be hedged – Interest Rate – Exchange Rate – Commodity Price

138

Interest Rate Volatility • Debt is a key component of a firm’s capital structure • Interest rate hedges can stabilize borrowing costs • Some tools: forwards, futures, swaps, options

139

Exchange Rate Volatility • International businesses are exposed to exchange rate risk • Tools for managing exchange rate risk – forwards – futures – swaps

140

Commodity Price Volatility • Costs of materials can be volatile: – Pricing becomes problematic – Sales demand becomes harder to predict

• Hedging allows for: – Better production decisions – Reduced volatility in cash flows

• Available tools (depending on the type of commodity): – – – –

Forwards Futures Swaps Options 141

Reducing Risk Exposure • Hedging will not normally reduce risk completely – Typically, only price risk can be hedged  not quantity risk – Reducing risk completely causes loss of potential upside

• Timing – Short-run exposure can be managed in a variety of ways – Long-run exposure almost impossible to hedge

142

Forward Contracts • A contract between parties – Agreement today on the price of the asset on the delivery date – Delivery and payment is specified for a future date

• Forward contracts are legally binding on both parties • Positions – Long: – Short:

Agrees to buy the asset on the future date Agrees to sell the asset on the future date

• Key points – Negotiated contract – No exchange of cash initially – Usually limited to large, creditworthy corporations

143

Payoffs on Forward Contracts

144

Hedging with Forwards • Forward contracts can virtually eliminate price risk • New risk created: Credit risk of the counterparty • Forward contracts are primarily used to hedge exchange rate risk

145

Futures Contracts • Futures traded on organized securities exchanges • Upfront cash payment: MARGIN – Small relative to the value of the contract – “Marked-to-market” on a daily basis • Clearinghouse guarantees contract performance • Clearinghouse and margin requirements virtually eliminate credit risk 146

Hedging with Futures • Futures contracts are standardized – Allows for trading – Exact hedging may be difficult or impossible

• Credit risk is virtually nonexistent • Futures contracts are available on – – – –

physical assets debt contracts Currencies equities

147

Swaps • A long-term agreement between two parties • Can be viewed as a series of forward contracts • Generally limited to large creditworthy institutions or companies

148

Option Contracts •

The right, but not the obligation, to buy (sell) an asset for a set price on or before a specified date – – – –

•

Call – right to buy the asset Put – right to sell the asset Exercise or strike price –specified price Expiration date – specified date

Buyer has the right to exercise the option; the seller is obligated – Call – option writer is obligated to sell the asset if the option is exercised – Put – option writer is obligated to buy the asset if the option is exercised

•

Options allow a firm to hedge downside risk, but still participate in upside potential

•

Pay a premium for this benefit 149

Buy a call with E = $40

Sell a Call E = $40

70

0

60

-10 0

50

-20

40

Payoff

Payoff

Payoff Profiles: Calls

30 20

20

40

60

80 100

-30 -40 -50

10

-60

0 0

20

40

60

Stock Price

80 100

-70 Stock Price

150

Payoff Profiles: Puts 45 40 35 30 25 20 15 10 5 0

Sell a Put E = $40 0 -5 0 -10

20

40

60

80 100

-15 Payoff

Payoff

Buy a put with E = $40

-20 -25 -30 -35 -40

0

20

40

60

Stock Price

80 100

-45 Stock Price

151

Retention vs. Transfer • • • • • • • •

Ability to Bear the Loss Cost and Effectiveness of a Transfer Degree of Control over the Risk Insurance Loading Fees Additional Insurer Services Insurance as a Signal Opportunity Costs Taxes 152

Risk Financing Methods • Guaranteed Cost Insurance • Experience-Rated Insurance • Retrospective Rating 153

Guaranteed Cost Insurance  Underwriting  Premium Depends on Classification Group  Premium = (A)* (PURE PREMIUM) + B

154

Pure Premium # cars = 10,000 # losses = 250 $ losses = $4.5 million Pure Premium = frequency x severity Frequency = 250 / 10,000 = 2.5% Severity = $4.5 million / 250 = $18,000 Pure Premium = 2.5% (18,000) = $450 A = 1.4 B = $50 1.4 (450) + 50 = $680

155

Underwriting Considerations • • • • • •

Adverse Selection Misclassification Control Civil Rights Costs of Classification Social Policy 156

What’s Fair and Why Health Insurance Underwriting Factors

• • • • • • •

Cigarette Smoking Obesity Age Prior history of heart disease Genetic Predisposition to Stomach Cancer Gender Race 157

State Underwriting Restrictions: Health Insurance • CALIFORNIA:

Blindness, Gender, Marital Status, DES

• N. DAKOTA:

Blindness, Gender, Race

• WISCONSIN:

Blindness, Gender, Physical Impairment

158

How Insurance Works An Example Assume an individual has a 1% probability of getting cancer and incurring medical expenses of $200,000. How much would you charge to bear this risk?

159

How Insurance Works

Central Limit Theorem Mean = True Mean Law of Large Numbers Increase sample size by N  New Mean = Old Mean x N  New S.D. = Old S.D. x Sq. Root of N

160

HOW INSURANCE WORKS AN ILLUSTRATIVE EXAMPLE Sample Size = 1,000 Mean = 10 S.D. = 2 Loss per claim = $200,000

4

6

8

10

12

14

S.D. Prob. 1 68.27 2 95.45 3 99.73

16

161

HOW INSURANCE WORKS AN ILLUSTRATIVE EXAMPLE For 99.73% survival prob. insurer will charge: 16 x $200,000 = $3,200 1,000 Increase sample size to 100,000 (100x) Mean # of Losses = 10 x 100 = 1,000 S.D. = 2 x sqroot (100) = 20 Now for 99.73% survival prob. insurer will charge: 1060 x $200,000 = $2,120 100,000

162

Requirements of an Insurable Risk 1. 2. 3. 4. 5.

Large Number of Homogenous Exposure Units Accidental Determinable and Measurable No Simultaneous Destruction Probability Calculable and Not Too High

 suicide, space shuttle, mental illness, war,  early flight and computers, terminally ill 163

Social and Economic Value of Insurance • • • • • •

Stability Indemnification Reduction in Reserve Funds Insurers’ Ability to Invest Satisfies Financial Requirements Specialization in Loss Prevention 164

Social Costs of Insurance • Insurers’ Operating Costs

• Moral Hazard • Exaggeration of Losses

165

Cheating with Insurance

• Insurer – – – –

Failure to Honor the Contract Misleading Contracts False Advertising Inappropriate Sales

• Insured – Fraud 166

Controlling Cheating

• Litigation • Regulation

167

Litigation Requirements of an Insurable Contract

• Offer and Acceptance

• Consideration • Competent Parties • Legal Purpose 168

Litigation Legal Principles: Indemnity • Valuation – Property: ACV – Liability: Actual Damages

• Apparent Exceptions – Valued Policies – Replacement Cost Insurance – Life Insurance 169

Actual Cash Value Example

ACV = Replacement Cost – Depreciation 1/1/04: Buy Machine for $3,000, 10 year life 1/1/06: Fire Destroys Machine; New Machine Costs $10,000 ACV = $10,000 - $2,000 = $8,000

170

Litigation Principle of Insurable Interest • Property and Liability: Time of Loss – Ownership – Potential Legal Liability – Secured Creditors

• Life Insurance: Time of Policy Purchase – Close Ties: Love, Blood, Marriage – Pecuniary Interest 171

Litigation Principle of Subrogation

• Prevents Double Indemnification • Holds Down Insurance Costs

172

Litigation Principle of Utmost Good Faith

• Representations • Concealment • Warranty

Is It Material? 173

Why Is Insurance Regulated?

• Advance Payment of Premiums • Complexity of Transaction

174

Types of Regulation • • • • •

Licensing Solvency Rate Approval Agents’ Activities Insurance Contracts

175

Insolvency: Major Reasons

• • • • • •

Bad Management Poor Underwriting Inadequate Reserves Bad Investing Inattentive to Loss Prevention Competitive Pressures

176

Danger of Insolvency • Most Insurers are Very Solid • 100+ Years – 71 Life Insurers – 200 Property and Liability Insurers

• Guaranty Funds • Buyout of Failing Firms

177

Premium Regulation

• Adequate • Fair • Reasonable 178

Methods of Rate Regulation • Prior Approval • File and Use

• Open Competition

179

Advantages of Open Competition

• • • •

Flexibility Increased Availability of Insurance Avoid Political Fights Frees Time of Regulators

180

Disadvantages of Open Competition • Price Gouging (?)

• Risk of Insolvency (?) • Fair (?)

181

Regulation of Agents’ Activities • Licensing • Prohibited Acts – Twisting – Rebating

182

Causes of Insurance Market Failure • Adverse Selection • Individuals Underestimate the Loss Potential • Insurance Costs Too Much • Pooling Not Possible • Insurers Can Not Estimate the Loss Potential 183

THE END

184