PowerPoint Slides for Professors Spring 2010 Version

1. PowerPoint Slidesfor Professors Spring 2010 Version This file as well as all other PowerPoint files for the book, “Risk Management and Insurance: Perspectives in a Global Economy” authored by Skipper and Kwon and published by Blackwell (2007), has been created solely for classes where the book is used as a text. Use or reproduction of the file for any other purposes, known or to be known, is prohibited without prior written permission by the authors. Visit the following site for updates: http://facpub.stjohns.edu/~kwonw/Blackwell.html. To change the slide design/background, [View]  [Slide Master] W. Jean Kwon, Ph.D., CPCUSchool of Risk Management, St. John’s University101 Murray StreetNew York, NY 10007, USA Phone: +1 (212) 277-5196E-mail: Kwonw@stjohns.edu

2. Risk Management and Insurance: Perspectives in a Global Economy 19. The Economic Foundations of Insurance There are two sections (Insurance Legal Principles; Insurance Contract Structure). Both are derived from Appendix Chapter 2. Click Here to Add Professor and Course Information

3. Study Points • Expected utility and the demand for insurance • Insurance supply: characteristics of ideal insurable exposures

4. Expected Utility and the Demand for Insurance

5. Recall the Cases • John and Mary • Risk-averse utility function • XYZ Insurance • Expected value theory • Premium at cost

6. How Premium Is Calculated? • Cost  expected loss • Loadings for • Internal expenses (e.g., underwriting and marketing) • External fees (e.g., premium taxes and license fees) • Profits

7. Moral Hazard • The propensity of individuals to alter their behavior when risk is transferred to a third party, such as being less careful in: • Maintaining health condition • Driving • House maintenance • Fraud as an extreme case

8. Insurance Demand in Markets with Moral Hazard Discussion in page 482 • Ex-ante moral hazard • Insurance fraud • Ex-post moral hazard • Insurer responses to moral hazard • Controlling the marginal benefit of being careful or the marginal cost of being careless • Loss sharing through deductible and coinsurance • Insight 19.2 • Rewarding insureds who undertake loss preventing activities • Retrospective or experience rating

9. Moral Hazard and Insurance DemandAndrew • Andrew, risk-averse salesperson • Has €12,000 in cash and a car worth €4,000 • Probability of accident depending on his driving behavior • If not careful, p = 0.5 • If careful, p = 0.2 but incurs additional expense of €1,000 • Has a square root function for his wealth utility

10. Moral Hazard and Insurance DemandEcu Insurance • Ecu Insurance Company • Full insurance at the actuarially fair premium • Should it consider Andrew is a safe or risky driver? • If a safe driver: premium = 0.2 x €4,000 = €800 • Otherwise: premium = 0.5 x €4,000 = €2,000

11. Insurer Responses to Moral Hazard • Controlling the marginal benefit of being careful or the marginal cost of being careless • Loss sharing through deductible and coinsurance • Insight 19.2 • Rewarding insureds who undertake loss preventing activities • Retrospective or experience rating

12. Stop loss Coinsurance Coinsurance Deductible Deductible Insured’s Share Insurer’s Share Deductible and Coinsurance (Insight 19.2)

13. Deductible and Coinsurance (Another Look) Frequency Amount Financed Amount Retained Coinsurance Stop Loss Severity Deductible Coverage Limit

14. Insurance Demand in Markets with Adverse Selection Discussion in page 485-486 • The effect of adverse selection on insurance markets • Insurer responses • Eliciting more information about applicants and insureds • Designing insurance contracts that encourage insureds with differing risk types to self-select into the most appropriate risk class • Table 19.1

15. Adverse Selection and Insurance DemandIndividual Rating • Two Japanese • Risk averse and each with initial wealth of ¥125,000 • Will suffer a ¥100,000 loss if cancer develops • One is “low risk” (p = 0.25) and the other is “high risk” (p = 0.75) • Insurance at actuarially fair premium

16. Adverse Selection and Insurance DemandPooled Rating • If the insurer pools both risks • Fair pooled premium [(¥75,000 + ¥25,000) ÷ 2] = ¥50,000

17. A Solution • Eliciting more information about applicants and insureds • Designing insurance contracts that encourage insureds with differing risk types to self-select into the most appropriate risk class

18. An Example Using a Simple Pricing Technique

19. Insurer’s Tool – Underwriting • Case • A city with one health insurer, Monopoly Insurance • All citizens must purchase health insurance. • There are 1,000 good risk citizens and 1,000 bad risk citizens. • Will the insurer classify them into high and low risk classes and charge different premiums? • No. Instead, it can treat all risks equal and charge the same premium. • No medical exam would be required.

20. Insurer’s Tool – Underwriting • Suppose • A good risk costs the insurer $1000 a year. • A bad risk costs the insurer $5,000 a year. • The pooled premium is then:

21. Insurer’s Tool – Underwriting Medical Exam Required Those Who Pass Gets the Coverage for $2,000 of yearly premium. Those Who Fail Gets the Coverage for $4,000 of yearly premium. • Suppose now • Competition Insurance enters the market. • It has the risk information of the city. • It wants to generate profits with minimum effort. Possible? • The result • Monopoly Insurance goes out of business.

22. Substitutes for Insurance • Substitutes • Higher insurance prices tend to decrease the amount of market insurance purchased by risk-averse individuals and increase the amount of loss reduction “bought.” • Complements • Loss prevention and market insurance are complements, not substitutes. • An investment in loss prevention may actually raise the amount of risk that a risk-averse person faces and therefore raises the demand for market insurance.

23. Why Corporations Purchase Insurance

24. Why Corporations Purchase Insurance Discussion continues from Chapter 2 • Already covered are: • Managerial self-interest • Corporate taxation • Cost of financial distress • Capital market imperfections • Other reasons include: • Insurers may offer real service efficiencies. • Regulated industries have a higher demand for insurance. • The purchase of some types of insurance is required by government.

25. “Ideal” Insurable Exposures– Not Necessarily Practical in Some Aspects

26. “Ideal” Insurable Exposures • Presence of numerous independent and identically distributed (IID) units • Unintentional losses • Easily determinable losses as to time, amount, and type • Economically feasible premium

27. Numerous IID Exposure Units • Each exposure unit (e.g., liability risk) in an insurance pool should be IID. • Two random variables (e.g., exposures units) are independent if the occurrence of an event affecting one of the variables has no affect on the other variable. • The independence property is important because it affects how well insurers can diversify the systematic risk of their insurance pools. • Random variables are identically distributed if the probability distributions of two random variables prescribe the same probability to each potential occurrence.

28. Numerous IID Exposure Units • The law of large numbers • Variance and standard deviation as measures of dispersion • Effects of pooling IID exposures units – A fire insurer would be interested in the following four statistics: • The total amount of losses expected to be paid during the year; • The standard deviation of the total loss distribution (to understand the riskiness inherent in providing this insurance) • The average loss (to determine the premium to be charged); • The standard deviation of the average loss distribution (to determine the risk each exposure unit contributes to the risk class)

29. Average Loss Distribution of an Insurance Pool (Figure 19.2)

30. Probability of Ruin (Figure 19.3)

31. Accidental Losses • Losses should be accidental or unintentional • We made this point earlier in the context of moral hazard • From a societal viewpoint, it clearly is not good public policy to allow policyholders to collect insurance proceeds for internationally causing losses. • Some losses occur naturally over time. • It is usually less expensive to budget for possible repair or replacement of the property than to purchase insurance.

32. Determinable Losses • The details of the insured loss – time, place, and amount – must be verified and the payment amount agreed upon by the insured and the insurer. • The costs of verifying loss details should be relatively low for insurance to be offered at an economically feasible premium.

33. Economically Feasible Premiums • On the one hand, rational risk-averse individuals will pay a maximum premium equal to the expected value of the loss plus the risk premium. On the other, the owners of private insurance companies require that insurance rates be enough to give them a competitive return on their investments. • Factors affecting this range • Competition in the market • Threats of new entrances • Price • Threat of alternative products and substitutes • The bargaining power of consumers • The degrees of risk attitudes of consumers

34. Legal Aspects: A Short VisitAppendix Chapter A2

35. Legal Principles • Indemnity • Insurable interest • Utmost good faith

36. Indemnity • In nonlife insurance • Actual cash value (ACV) • Replacement cost • Valued policy • Other insurance provision • Primary and excess insurance Figure A2-1 • Subrogation

37. Excess Primary Another Example of Primary and Excess Personal Umbrella Liability Insurance (Liability Coverage) $1,000,000 Homeowner’s (Liability Coverage) $500,000 Personal Automobile (Liability Coverage) $300,000

38. Indemnity • In life insurance • No application of “other insurance” provision • When applied, it could be in relation to the total earnings power of the insured life and the sum of life insurance in the aggregate of all outstanding policies • Thus, life insurance policies are “valued policies.” • In health insurance • ‘Coordination of benefits”

39. Insurable Interest • The principle: • An insured must have a financial interest in the loss event that is the subject of the insurance contract for the policy. • Application in • Nonlife insurance • Bailment • Life insurance • Insurable interest for domestic partners  Insight A2-2 • Viatical Settlements (and Death Bonds)  Insight A2-3 Bailment – Temporary change in possession of property but with no change in ownership

40. Utmost Good Faith • A higher degree of honesty on the parties to an insurance contract than what is expected from parties to other [legal] contracts • Information asymmetry problem inherent with insurance contracts Good faith Utmost Good faith http://www.lawyersrealestate.com.au/blogger/2006_04_01_archive.asp; http://www.freerepublic.com/focus/f-news/1780026/posts

41. Utmost Good Faith – Applications Materiality? • Misrepresentation • Material response incorrectly made by an applicant in procuring insurance • Concealment • Intentional failure to disclose material information • Warranty • Statement of fact or promise that must be true for the insurer to be liable under the insurance contract

42. When "material" misrepresentation or concealment is found..., The contract becomes "voidable." Cancelled Contract? Void Contract?

43. Insurance Contract: A Short VisitAppendix Chapter A2

44. Characteristics • Aleatory contract • The values exchanged by the contracting parties may not seem equal. • Unilateral contract • Only one party (the insurer) has a legal duty to act. • Conditional contract • The insurer is obligated to honor its promises only if the insured has complied with certain conditions specified in the policy.

45. Characteristics (continued) • Personal contract • The agreement is between the insurer and the insured person (not the insured property). • Hence, property insurance contracts cannot be assigned to another insured person without the insurer’s consent. • Contract of adhesion • The contract is designed by one party and offered to another party on a "take it or leave it" basis. • Reasonable expectations doctrine • It considers the objectively reasonable expectations of insureds and beneficiaries regarding the terms of insurance contracts.

46. The Insurance Contracting Process • Offer and acceptance • Binding authority • Conditional premium receipt • Consideration • Insurer – promise to pay the stipulated insurance benefits • Insured – complete application and initial premium payment • Legal competence • Age? • Legal purpose

47. Structure of the Insurance Contract • Declarations • Insuring agreements • Exclusions • Conditions • Endorsements (riders)

48. Declarations (Page) Insight A2-4Automobile Liability Insurance Limits • Policy limits • Aggregate limits • Sublimits such as: • Per person limit • Per occurrence limit • Loss sharing • Deductible • Elimination period (e.g., health insurance) • Coinsurance

50. Insuring Agreements • Describes the nature of the insurer's obligations: • Promises to pay certain sums upon the occurrence of enumerated events, for example: • Property damage to covered property caused by insured perils • Payment for settlements and judgments when the insured is found legally liable for activities covered in the contract • Plus a duty to defend the insured against all allegations • Life insurer’s promise to pay the beneficiary (or insured) certain amounts upon the death (or survival) of the insured • In health insurance, reimbursement of covered medical expenses or the periodic payment of income for covered disabilities