Introduction to Risk Management and Insurance, 7E - Dorfman

1. Introduction to Risk Management and Insurance, 7E - Dorfman Chapter 1: Fundamentals and Terminology

2. OVERVIEW OF COURSE INSURANCE AND RISK MANAGEMENT TERMINOLOGY PRINCIPLES COMPANIES (MACRO) COMPANIES OCCUPATIONS CONSUMERS Government CONTRACTS & PERSONAL INSURANCE LIFE CONTINGENCIES COMMERCIAL INS. & ADVANCED RISK MANAGEMENT SOCIAL PROGRAMS

4. Insurance Benefits to Society • Stability of families • Aids planning ability to businesses • Facilitates credit transactions • Anti-monopoly device • Reduces credit costs • Increases efficiency of capital

5. Costs to Society • The costs of operating the insurance mechanism • Commissions • Overhead of the company • Exaggerated claims • Intentional losses (moral) • General indifference about the way we treat our property, etc. (morale) • Does not include losses that would have occurred anyway

6. The Problem of ArsonIllustration of Loss Costs • What is Arson? • What is Arson-for-Profit? • What are the costs? • Who really pays for Arson? • Should insurance companies be substituted for the role of public law enforcement authorities?

7. INTRODUCTIONDefinitions and terms • Insurance • Two main elements 1) Financial intermediation 2) Contractual relationship • Loss (definition of) • Types of losses • Direct Loss • Indirect Loss • Chance of Loss • Number expected / Total exposed = Fraction

8. INTRODUCTIONDefinitions and terms • Peril - The cause of a loss or contingency that causes a loss • “Named peril” or Specified peril contracts • ”Open-peril" contracts • burden of proof • Hazard • Something that increases the probability of loss or increases the severity when a loss occurs • physical, moral, morale

9. INTRODUCTIONDefinitions and terms • Proximate cause of the loss • Also known as Doctrine of proximate cause • First insured peril in an unbroken chain of events leading to the loss - all is paid.

10. INTRODUCTIONDefinitions and terms • Risk - many definitions - the term is used in a variety of ways 1) To describe that there is a possibility of loss 2) To identify the probability of loss 3) To identify the cause of loss - peril 4) To identify conditions that increase frequency of severity of loss - hazard 5) To identify the property or person exposed 6) To identify the potential $ amount of loss 7) To describe the variation in potential losses – the ability to predict

11. Objective Risk - relative variation from expected • Degree of risk – the ability to predict • Not the same thing as probability of loss • Law of large numbers • Coefficient of variation = s/x = % of variation expected relative to the mean • OBJECTIVE RISK V. THE PROBABILITY OF LOSS

12. OBJECTIVE RISK V. THE PROBABILITY OF LOSS

13. OBJECTIVE RISK V. THE PROBABILITY OF LOSS

14. OBJECTIVE RISK V. THE NUMBER OF EXPOSURES

15. OBJECTIVE RISK V. THE NUMBER OF EXPOSURES

16. Risk - types • Subjective Risk - individual’s mental attitude concerning loss • Pure Risk - exposure that can only result in a loss or no change (two possible outcomes) • Speculative Risk - exposure that can only result in a loss, no change, or gain (three possible outcomes)

17. Risk Management • Logical process used by firms and individuals to deal with exposures to loss. • Involves pre-loss planning concerning the use of post-loss resources to minimize overall costs. • Continuous process that identifies exposures and decides how to deal efficiently with them. • Post-loss activities puts the plans into action.

18. Insurance works well when: • Many individuals purchase • Few people collect • Keeps rates affordable

19. Mathematical Basis for insurance - Example • Houses in pool 10,000 • Avg. value of each $ 80,000 • Total property value $ 800 million • Predicted losses = 1.5% of value $12 million • Predicted Loss per house $ 1,200 • Rate per $100 of value $ 1.50

20. Mathematical Basis for insurance - Example continued • Insurance Premium • Cost of losses $ 1.50 • Admin. costs .45 • Reserves for unexpected losses .10 • Investment Earnings (0.07) • Rate per $100 value $ 1.98

21. Concepts: • Cash flow underwriting • Loss ratio • Expense ratio • Combined ratio • Salvage

22. Insurance Benefits to Society • Stability of families • Aids planning ability to businesses • Facilitates credit transactions • Anti-monopoly device • Reduces credit costs • Increases efficiency of capital

23. Costs to Society • The costs of operating the insurance mechanism • Commissions • Overhead of the company • Exaggerated claims • Intentional losses (moral) • General indifference about the way we treat our property, etc. (morale) • Does not include losses that would have occurred anyway

24. The Problem of ArsonIllustration of Loss Costs • What is Arson? • What is Arson-for-Profit? • What are the costs? • Who really pays for Arson? • Should insurance companies be substituted for the role of public law enforcement authorities?