INS 3103 - Chapter 1
INS 3103 - Chapter 1 INS 3103
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This 7 page Class Notes was uploaded by Tina Ta on Saturday February 6, 2016. The Class Notes belongs to INS 3103 at Mississippi State University taught by Seth Pounds in Fall 2015. Since its upload, it has received 36 views. For similar materials see Principles of Insurance in Business at Mississippi State University.
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Date Created: 02/06/16
Chapter 1: Risk and its treatment I. What is Risk? A. Different definitions of risk; risk historically has been defined as uncertainty. - Risk: Uncertainty concerning the occurrence of a loss. Is there a risk you will die in an auto accident today? Yes, because there is uncertainty - Loss exposure: is also used by many authors and corporate risk managers to define risk. Any situation or circumstance in which a loss is possible, regardless of whether a loss occurs. Are defective products a loss exposure? Yes, possible lawsuits B. Objective Risk 1. Is the relative variation of actual loss from expected loss. 2. Declines as the number of exposure units increases 3. Can be measured by using the standard deviation or coefficient of variation - E.g: 10,000 houses are insured with 1% (100) burning each year. Some years as few as 90 may burn and others as many as 110. What is the variation? 10 houses from the expected number of 100. What is the objective risk? 10/100 = 10% - It’s important to note that the law of large numbers states that as the # of exposure units increases, the more closely the actual loss experience will approach the expected loss experience. C. Subjective Risk 1. Defined as uncertainty based on person’s mental condition or state of mind 2. Difficult to measure - E.g: 2 people have been drinking (equally drunk) at a bar and need to get home. One has previous DUI conviction the other person does not. Is there uncertainty on what to do? Yes. At the present moment which do you believe has a higher subjective risk which will result in conservative and prudent behavior? The person with a previous DUI conviction because he/she knows what the consequences of a DUI are and doesn’t want a DUI 2 . It’s a risk or more of a risk to one over the other. ( It’s also important to make a distinction btw obj. risk and sub. Risk) II. Chance of Loss: is the probability that an event that causes a loss will occur. A. Objective Probability: refers to the long-run relative frequency of an event based on the assumptions of an infinite number of observations and of no change in the underlying conditions. This can be don’t through deductive or inductive reasoning. - E.g: The probability of getting a head from the toss of a coin? 1/2 , bc there are 2 sides and only 1 is a head. Objective probabilities can be determined through inductive reasoning. Trying to determine probability that a person age 21 will die before age 26 cannot be don’t logically deduced. - E.g: Analyzing past mortality rates in order to determine the probability of death for a certain age group. 1. A priori—by logical deduction such as in games of chance 2. Empirically—by induction, through analysis of data B. Subjective Probability: is the individual’s personal estimate of the chance of loss. It need not coincide with objective probability and is influenced by a variety of factors including age, sex, intelligence, education, and personality. - E.g: When you buy a lottery ticket do you use certain numbers? Why? B/c you believe you have a better chance to win. C. Chance of Loss Distinguished from Risk—although chance of loss may be the same for two groups, the relative variation of actual loss from expected loss may be quite different. The chance of loss may be identical for 2 different groups, but objective risk may be quite different. (have e.g in phone) III. Peril and Hazard A. Peril—defined as the cause of loss. - What’s the peril in an auto accident? In an auto accident, the collision is the peril. B. Hazard: is condition that increases the chance of loss – There are 4 types: 1. Physical hazard— is physical condition that increases the chance of loss/ the frequency/ severity of loss. - E.g: icy streets, poorly designed intersections, and dimly lit stairways. 2. Moral hazard—is dishonesty or character defects in an individual that increase the chance of loss/frequency/severity of loss. - E.g: Faking an accident to collect. 3. Attitudinal (Morale) hazard— is carelessness or indifference to a loss, which increases the frequency or severity of loss. Leaving the keys in an unlocked car. Changing lanes suddenly in heavy traffic. 4. Legal hazard—characteristics of the legal system or regulatory environment that increase the frequency or severity of loss. Large jury verdicts. Regulatory changes by the state insurance dept. IV. Basic Categories of Risk A. Pure and Speculative Risk 1. Pure risk—a situation where there are only the possibilities of loss or no loss. E.g: earthquake, premature death, damage to property, job-related accidents. 2. Speculative risk—a situation where either profit or loss is possible - E.g: Gambling, investing, going into business. B. Diversifiable Risk and Nondiversifiable Risk: Diversifiable risk affects only individuals or small groups (car theft, robberies, dwelling fires.); it can be reduced or eliminated by diversification. It’s also called nonsystematic or particular risk. Only individuals + business firms that experience such losses are affected – not the entire economy. The same concept is true with insurers. - E.g: a company that insures more than one line (auto, homeowners, long-term care). Losses on 1 line can be offset by profits on the other. Nondiversifiable risk affects the entire economy or large numbers of persons or groups within the economy (hurricane) and cannot be eliminated or reduced by diversification. - E.g: Rapid inflation, floods, earthquakes. - The distinction between the two is important b/c Government assistance may be necessary to insure nondiversifiable risk. - E.g: +) State unemployment comp./ fed. Flood ins programs. +) These risk are difficult (not impossible) to insure privately. C. Enterprise Risk—encompasses all major risks faced by a business firm, including pure risk, speculative risk, strategic risk, operational risk, and financial risk. Strategic risk: refers to uncertainty regarding the firm’s financial’ goals and objectives. - E.g: A firm entering a new line of business. Operational risk: results from the firm’s business operations. - E.g: A bank’s online operations may be hacked (Target). Financial risk: refers to uncertainty of loss b/c of adverse changes in commodity prices, interest rates foreign exchange rates, and the value of money. 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 - As long as all risks are not perfectly correlated, the firm can offset 1 risk against another, thus reducing the firm’s overall risk. - Treatment of financial risk requires use of complex hedging techniques, financial derivatives, futures contracts and other financial instruments. V. Major Personal Risks and Commercial Risks A. Personal Risks: are risks that directly affect and individual or family. They involve the possibility of a loss or reduction in income, extra expenses/depletion of financial assets, due to: 1. Premature death of family death 2. Insufficient income during retirement (graph p.8) 3. Poor health (can cause catastrophic medical bills and loss of earned income) 4. Involuntary unemployment - E.g: Exhibit 1.1 in phone B. Property Risks: involve the possibility of losses associated w destruction or theft of property. - E.g: Fire, lightning, tornado. -> There’re 2 major types of losses associated w Property (Direct vs Indirect) 1. Direct loss: is a financial loss that results from the physical damage, destruction, or theft of the property, such as: fire damage to a home. 2. Indirect or consequential loss: is a financial loss that results indirectly from the occurrence of a direct physical damage or theft loss. - E.g: the additional living expenses after a fire. C. Liability Risks: involve the possibility of being held legally liable for bodily injury or property damage to some else. These are of great importance b/c: There is no max upper limit w respect to the amount of the loss. A lien can be placed on your income and financial assets. Legal defense costs can be enormous. - Who pays for these legal defense cost? D. Commercial Risks: - Firms face a variety of pure risks that can have serious financial consequences if a loss occurs: 1. Property risks: such as damage to buildings, furniture, office equipment. 2. Liability risks: such as suits for defective products, pollution, sexual harassment. 3. Loss of business income: when the firm must shut down for some time after a physical damage loss. 4. Other risks to firm— include: crime exposures, human resources exposures, foreign loss exposures, intangible property exposures, government exposures. - What did we say ab pure risk? -> They’re easier to insure. VI. Burden of Risk on Society: - The presence of risk results in 3 major: Need for a Larger Emergency Fund: - In the absence of ins, how would someone pay for losses? Individuals + business firms would have to maintain large emergency funds to pay for unexpected losses. Loss of Needed Goods and Services: - The risk of a liability lawsuit may discourage innovation, depriving society of certain goods and services. Risk causes worry and fear (mental unrest). VII. Techniques for Managing Risk: (2 types) A. Risk Control: refers to techniques that reduce the frequency of severity of losses: 1. Avoidance: - E.g: How do avoid the risk of being mugged in a high crime area? - E.g: How you avoid the risk of getting divorced? 2. Loss prevention: refers to activities to reduce the frequency of losses. - E.g: How do you prevent auto accidents? Safe-driving courses/ strict security measure at airports? 3. Loss reduction: activities to reduce the severity of losses – some losses are inevitable. - E.g: Fires – sprinkler systems, firewalls, Tornado- community warning system. B. Risk Financing: techniques that provide for payment of losses after they occur. 1. Retention: an individual or business firm retains part or all of the losses that can result from a given risk. -> Retention can be active or passive: Active retention: an individual is aware of the risk + deliberately plans to retain all of part of it. - E.g: Purchasing ins w a deductible (you have retained some risk). Passive retention: risks may be unknowingly retained b/c of ignorant, indifference, or laziness. - E.g: Being unaware of the importance of obtaining total and permanent disability ins (severe financial consequences) Self ins: is a special form of planned retention by which part or all of given loss exposure is retained by the firm (also called self- funding). 2. Noninsurance transfers: transfers a risk to another party. A transfer of risk by contract, such as through a service contract or a hold-harmless clause in a contract (risk of rent increases – long-term lease). Hedging: technique for transferring the risk of unfavorable price fluctuations to a speculator by purchasing and selling futures contracts on an organized exchange. Incorporation of a business firm: transfers to the creditors the risk of having insufficient assets (not the owner if it’s a sole proprietorship) 3. Commercial insurance: - For most people, ins is the most practical method for handling major risk: Risk transfer: is used b/c to spread the losses of the few over the entire group. The risk may be reduced by application of the law of large numbers.
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