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The Griffith Insurance Education Foundation
Risk Management Principles and
The Role of InsuranceDavid T. Russell, Ph.D.
Director, CSUN Center for Risk and InsuranceMarch 14-15, 2013
What is Risk? In short, Risk = Uncertainty Two Kinds of Risk
Pure Risk: Possibility of Loss Speculative Risk: Possibility of Profit
or Loss Example of Pure Risk: Driving a Car Example of Spec Risk: Buying a Stock
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Risk Management RM is Treatment of Exposure to Risk Five Main Methods of Risk Management
Avoidance (Refrain from Activity) Retention (Accept the Possibility of Loss) Loss Control (Steps to Reduce Freq or Sev) Non-Insurance Transfer (ex: Hold Harmless) Insurance (Transfer to a Pool for Premium) Usually, RM is a Combination of Methods
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Insurance Insurance Transfers Risk to a Pool
“Shares” Risk with Other Similar Risks An Insurance Policy is a Contract
Adjudicated and Regulated by State Law Designed to Indemnify Policyholder
“Insured” Should Not Profit from a Loss Profiting from Loss Contrary to Public Policy
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The Insurance Purchase Decision One or More Reasons to Buy Coverage
Required by Law, Lenders or Others Buyer is Risk Averse or Unsure About Risks Coverage is Mispriced (Rare)
One or More Reasons NOT to Buy Buyer Cannot Afford or Has Other Priorities Coverage Perceived as too Expensive Risk is Better Managed in Other Ways Coverage Not Needed
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Insurance is NOT Gambling Insurance Transfers Existing Pure Risk Gambling Creates New Speculative Risk Insurer Reduces Risk by Pooling Like Any Contract, Consideration a Must Aleatory: Consideration is Unequal
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Underwriting UW is Selection/Classification of Risk EQ Example for School UW Uses Application, MVR, MIB, Other Some UW Factors Illegal (Ex: Race) Underwriters Place Risks in Right Pool Insurer Loses $ if Many Risks Declined
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Moral Hazard Simply Put, Ins Changes Behavior
Carelessness—Less Vigilant if Insured Increased Utilization—Visit Doctor More FDIC—Pursue High Rate, Despite Risk Fraud—If Insured, Policyholder May
Intentionally Cause Losses to Collect Money Result—Higher Claims
How to Prevent MH? Law, Contract, UW
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Adverse Selection AS is Tendency of Risks to Seek
Coverage at Lower Rates Ex: “All-You-Can-Eat” Pricing Ex: Unisex Pricing Option Example: “No Medical Exam” Result: Without Underwriting, Ins
Pools Tend to End Up With High Risks Low Risks Tend to Drop Out
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The Insurance Mechanism Pooling of Similar Risks
Ex: 10,000 Toyota Camrys Using Historical Data, Losses Can Be
Predicted and Priced Appropriate Insurance Concepts
“Law of Large Numbers” “In the Long Run” “Diversified Portfolio”
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Insurable Risks Large Number of Exposures Losses Are Accidental and Random Losses Are Determinable & Measurable Chance of Loss is Calculable (Pricing) Premium is Economically Feasible Losses Are Not Correlated* Gov’t May Handle Uninsurable Risks
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The Insurance Mechanism Critical: Losses Cannot Be Correlated
Correlated Risks: EQ, Flood, Unemploy Ins Capital Required to Back Promises
Losses Can Exceed Expectations Usually, Capital is Called Equity or Net Worth Insurer Capital is Called “Surplus” Surplus is Cushion Against Unexpected Surplus Expects a Return in Normal Times
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Simplified Pricing Example 10,000 Toyota Camrys
Assume Avg Claim is $250 per 6 Months Insurer Must Add Expenses and Profit Assume 15% for Corporate/Underwriting Assume 15% for Commission Assume 5% for Profit $250 + 35% = $337.50 Avg Per Six
Months (Some Drivers Pay More, Less)
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Other Pricing Considerations Claims or Expenses May Come in High Owners Lose Money in “Bad” Periods Insurers May Purchase Reinsurance Insurer Receives Investment Income
Premiums Received Before Claims Paid Investment Holdings Regulated Investment Risks Can Affect Solvency
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Rate Regulation CA Requires Prior Approval for Auto, HO Market Forces Also Keep Rates Low Mature Mkt Means Fierce Competitors Consumers Benefit from Competition Inadequate Rates Threaten Everyone Insolvency Costs Spread to Other Cos.
State Guaranty Fund Assessments
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Rate Regulation Pricing Reflects Costs and Market Structure Ins “Cost” is a Forecast, Rather than Known Pricing Should Not Be Unfairly Discriminatory Rates Should Be Adequate, But Not Excessive
Cover Claim Costs, Overhead and Profit Capital Will Go Elsewhere Without Profit Profit Should Be Commensurate with Risk
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Solvency Surveillance Solvency = Sufficient to Pay Claims Surplus is Cushion Against Unexpected Surplus Does Not Mean “Too Much” $ Reserves Mean $ for Expected Claims Policyholders Trust Claims Will Be Paid DOI Actuaries Review Reserves
Reserves Reflect Estimated Claim Costs
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Solvency Surveillance:What Can Go Wrong?
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Assets LiabilitiesCash 1,000,000 Unearned Premiums 500,000
Investments 9,000,000 Reserves 7,500,000
Surplus 2,000,000
Total 10,000,000 Total 10,000,000
Note: Insurance companies use different, more “stable” accounting rules called Statutory Accounting.
US Insurance Market Very Large and Mature; Little Growth Divided into Two Main Sectors
Property/Casualty Insurance Life/Health (Includes Annuity Products)
Larger Organizations May Self Insure to Avoid Profit and Expense Loadings
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Source: SNL Financial, Inc.
$502B
$576B
$175B
2011 U.S. Net Premiums Written
P&CLifeA&H
2011 P&C U.S. NPW by Line
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2011 Life/A&H NPW by Line
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The California Insurance Market
CA Represents About 11.29% of US Mkt $124.5b in Premiums Written (2011) Roughly 200,000 Agents Licensed in CA Roughly $2.3b in Premium Taxes Paid
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Policy Forms Standardized Contracts of Insurance Vetted Over Decades of Litigation Changes Require Approval by State Interpreted in State Courts Ambiguities Interpreted Against Insurer Smaller Insurers License Forms from
ISO (Insurance Services Office), etc.
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Policy Forms Policies Include Insuring Agreement,
Definitions, Conditions, Exclusions, Etc. Can Be Amended with Endorsements Policy Provisions Designed to Reduce
Moral Hazard, Adverse Selection, Fraud Ex: Mold Exclusion Ex: Suicide Clause Ex: Must Cooperate w/Investigators
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Feel free to contact me:David T. Russell, Ph.D.California State University, Northridge(818) [email protected]
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Any Questions?