Risk Management Principles and The Role of Insurance

1. INFORM+INSPIRE Risk Management Principles and The Role of Insurance Washington, D.C. April 29th, 2013 James M. Carson, Ph.D. CPCU, CLU, ARM The University of Georgia The Griffith Insurance Education Foundation

2. Risk • Focus on Fundamentals • Some review of familiar terms / concepts likely (see materials) • Plus some new thoughts / concepts • Comments / Questions Welcome The Griffith Insurance Education Foundation

3. Risk is Ubiquitous • Personal/Individual • Family • Business • Government The Griffith Insurance Education Foundation

4. Risk Risk The Griffith Insurance Education Foundation

5. Top 16 Most Costly Disastersin U.S. History (Insured Losses, 2012 Dollars, $ Billions) Hurricane Sandy could become the 4th or 5thcostliest event in US insurance history Includes Joplin, MO, tornado Includes Tuscaloosa, AL, tornado 12 of the 16 Most Expensive Events in US History Have Occurred Over the Past Decade Hurricane Irene became the 12th most expense hurricane in US history in 2011 The Griffith Insurance Education Foundation Insurance Information Institute.

6. US Insured Catastrophe Losses $100 Billion CAT Year is Coming Eventually ($ Billions) 2000s: A Decade of Disaster 2000s: $193B (up 117%) 1990s: $89B Record Tornado Losses Caused 2011 CAT Losses to Surge 2011 was one of the Most Expensive Year in History for Insured Catastrophe Losses in the US *Estimate through Oct. 31, 2011. Note: 2001 figure includes $20.3B for 9/11 losses reported through 12/31/01. Includes only business and personal property claims, business interruption and auto claims. Non-prop/BI losses = $12.2B. Sources: Property Claims Service/ISO; Insurance Information Institute. The Griffith Insurance Education Foundation 6 12/01/09 - 9pm eSlide – P6466 – The Financial Crisis and the Future of the P/C

7. Underwriting Gain (Loss)1975–2012:Q3* ($ Billions) Underwriting losses through 2012:Q3 totaled $6.7B Cumulative underwriting deficit from 1975 through 2011 is $479B High cat losses in 2011 led to the highest underwriting loss since 2002 Large Underwriting Losses Are NOT Sustainable in Current Investment Environment The Griffith Insurance Education Foundation * Includes mortgage and financial guaranty insurers in all years. Sources: A.M. Best, ISO; Insurance Information Institute.

8. What is Risk? • Traditional Definition • Risk = Uncertainty • Risk of Death? The Griffith Insurance Education Foundation

9. What is Risk? • A Better Definition • Risk = Uncertainty about chance, timing, or amount of loss • Risk of ____ death • Risk of poor health • Risk of car accident • Risk of house fire • Etc……. The Griffith Insurance Education Foundation

10. Types of Risk • Objective risk v. Subjective risk • Pure risk v. Speculative risk • Property risk (direct v. indirect) • Liability risk • (Ex: Corps of Engineers, Deepwater Horizon Spill) The Griffith Insurance Education Foundation

11. The Burden / Cost of Risk on Society • Need for Emergency Funds • Outlays to Reduce Risk • Opportunity Cost • Expense of Financing Potential / Actual Losses • Increased Prices • Loss of Certain Goods & Services • Worry and Fear • Time • Losses For Which We Are Not Indemnified The Griffith Insurance Education Foundation

12. Benefits of Managing Risk • Potential Enhancement of Credit • Indemnification for Losses • Less Worry and Fear—More Activity • Source of Investment Funds • (~$6 T Assets) • Loss Prevention Services • Private Efforts • Public Efforts (Ex: flood mitigation) The Griffith Insurance Education Foundation

13. Risk Management The Griffith Insurance Education Foundation

14. Risk Management • Definition: • Formal decision-making process to identify risk and minimize the cost of risk, including the potential financial consequences associated with loss exposures The Griffith Insurance Education Foundation

15. Risk Management Process • Identify loss exposures and select the most appropriate techniques for treating such exposures • Broader than simply Insurance • Trend toward “Enterprise Risk Management” • Loss Exposure: • Any asset exposed to loss; any situation in which a loss may occur The Griffith Insurance Education Foundation

16. Risk Management Process Identify Evaluate Select a Technique Avoid Retain Transfer Control Insurance Other Contractual Implement and Monitor The Griffith Insurance Education Foundation

17. Evaluating Loss Exposures • Loss Frequency • Car accident occurs every 5 _____ in U.S. • For most drivers, though, low frequency, 1 in 10 years • Loss Severity • Maximum Probable Loss • Maximum Possible Loss The Griffith Insurance Education Foundation

18. Frequency High Low High Severity Low Select Appropriate Technique: The Risk Management Matrix Avoid Insurance Retain Control/Retain The Griffith Insurance Education Foundation

19. Select an Appropriate Technique • Retention • Why would you/someone/firm retain risk? • How Much Can be Retained? • (Financial Capacity) • Active vs. Passive • Retention vs. Self-Insurance (Formal) • Disadvantages The Griffith Insurance Education Foundation

20. The Insurance Mechanism • Definition: • The pooling of fortuitous losses • By transfer of risks to insurer • Insurer agrees to indemnify for covered losses The Griffith Insurance Education Foundation

21. Basic Elements of Insurance • Pooling of losses • Losses are shared by the pool • Substitutes average loss ($xxx) for actual loss ($30,000 car) The Griffith Insurance Education Foundation

22. Basic Elements of Insurance • Replaces uncertain loss (risk) with certain payment (premium) • Unique in that pricing before the fact—don’t really know costs until after product is sold • Insurer uses law of large numbers and past experience to estimate premiums The Griffith Insurance Education Foundation

23. Pricing of Insurance – An Analogy • Substitutes average loss ($607) for actual loss The Griffith Insurance Education Foundation

24. Insurance Prices (Rates) • Objectives: Adequate, not excessive, not unfairly discriminatory • Conflicts among these goals The Griffith Insurance Education Foundation

25. Insurance Prices (Rates) • Methods vary by state and line of business • Personal lines generally are more strictly regulated than commercial lines • Often more concerned with rates that are too low rather than too high • Remaining insurers pay claims of failed insurers The Griffith Insurance Education Foundation

26. Basic Elements of Insurance… • Surplus • Insurer “Net Worth” = Owners’ Equity = A – L • For U.S. P-C Insurance Industry, ~$600 B • If, at end of the year (policy period): • Losses > expected, fund balance (“Surplus”) goes down • Losses < expected, fund balance (“Surplus”) goes up The Griffith Insurance Education Foundation

27. Basic Elements of Insurance • “Surplus” is the Insurance Mechanism’s “Cushion” and is what enables insurers to offer insurance • Premium / Surplus ratio concept (leverage) The Griffith Insurance Education Foundation

28. ‘Requirements’ of an Insurable Risk • Large Number of Homogeneous Exposure Units • Accidental and Unintentional Loss • Determinable and Measurable Loss • Calculable Chance of Loss • Economically Feasible Premium • If calculated premium is too high, probably • trying to insure something that is best _______ • Best suited for risks that have __S and __F The Griffith Insurance Education Foundation

29. Adverse Selection • Definition: • Phenomenon whereby people with higher-than-average chance of loss are more likely to seek insurance than average risks (e.g., ……) • i.e., the non-face cards don’t buy insurance, then the pool doesn’t collect $607 * 36 The Griffith Insurance Education Foundation

30. Adverse Selection • Consequences • Results in higher losses & expenses than expected • Prices increase • “Better” risks drop out of pool, prices increase…. • ”Death Spiral” The Griffith Insurance Education Foundation

31. Controlling Adverse Selection • Underwriting • Involves selecting and classifying insurance applicants • Certain standards that must be met for “standard” rates • If better than “standard,” lower rate applies • If < “standard,” higher rate applies • Policy Provisions • E.g., Suicide clause in life insurance The Griffith Insurance Education Foundation

32. Key Points about Adverse Selection • Risk pooling doesn’t work if the risk is too high • Risk pooling doesn’t work with too many high risks • Insurers need to be able to identify risk type so that they can put similar risks together in a pool to make it fair and affordable • Competition will drive premiums to the appropriate level for risk type The Griffith Insurance Education Foundation

33. The “Moral Hazard” Problem • Definition: Behavior change due to the presence of insurance that increase the frequency or severity of loss • Examples: • Faking accidents, disability • Exaggeration of claims • Failure to control losses (not locking car or house) • Intentional losses • Overutilization of insurance (e.g. health) The Griffith Insurance Education Foundation

34. Controls on Moral Hazard • Can’t insure in excess of the loss • Limits on underinsuring property • Careful claims adjusting • Deductibles and coinsurance • Waiting periods • Exclusions • Limits • Riders The Griffith Insurance Education Foundation

35. Societal Costs of Insurance • Cost of Claims • Outlays to Reduce Risk (Loss Control) • Increased moral hazard • Changes in behavior The Griffith Insurance Education Foundation

36. Societal Costs of Insurance….. • Cost of Ins. Mechanism --“Expense Load” • Cost (Expenses, Profits, Contingencies), including Inflated / Fraudulent Claims • Insurers do not “pay” claims We pay claims • Anything that increases outflow must have an inflow • EX: To insure expected losses of $5,000 would require premium of more than $5,000; so, for example, $5,000 + ~20% = ~$6,000 The Griffith Insurance Education Foundation

37. Brief overview of Basel 3 • Capital standards • Primarily geared toward banks • Gets applied to some insurers via Dodd-Frank Act The Griffith Insurance Education Foundation

38. Basel 3 cont… • Authorizes Federal Reserve Board regulation of • Savings and Loan Holding Companies (some of which own life insurers) • Nonbank Financial Companies (may include insurers that are deemed systemically important by the Financial Stability Oversight Council) The Griffith Insurance Education Foundation

39. Basel 3 cont… • Some Issues • Risk-Based Capital (RBC) and FAST exist for insurers • Long-term Assets vs. Short-term Assets • Bank-type regulation at federal level vs. insurer-type regulation at state level The Griffith Insurance Education Foundation

40. INFORM+INSPIRE Risk Management Principles and The Role of Insurance Thank you. For more information contact: The Griffith Insurance Education Foundation 7100 North High Street, Suite 200 Worthington, Ohio 43085 Phone: 855-288-7743 Email: info@griffithfoundation.org To download today’s presentation, please visit www.griffithfoundation.org/resources The Griffith Insurance Education Foundation