Risk Management Hurricane Katrina: Landfall August 29, 2005 1
Risk Management Hurricane Katrina: Landfall August 29, 2005 1 Fair Bet • Cost Equals Expected Gain • Cost = P * (Amount you Win) • Example: Flipping a Coin – Cost = $10 – P = .5 – Amount You Win = $20 2 Is This A Fair Bet? • Flipping A Coin – Cost = $50 – Amount You Win = $75 3 Risk Taking Behavior • Risk-Averse • Risk-Neutral • Risk-Taker (Risk-Seeker, Risk-Lover) 4 Risk and Uncertainty • Risk: A situation in which several different outcomes are possible. • Uncertainty: The perception that several different outcomes are possible. 5 Categorizing Risk • Pure Risk v. Speculative Risk • Diversifiable Risk v. Nondiversifiable Risk • Fundamental Risks and Particular Risks 6 Pure Risks v. Speculative Risks • Speculative Risks are Usually Chosen – Stock Appreciation – Manufacturing and Selling a Product – Example: Furby • Pure Risks are Usually a Byproduct – Automobile Accident – Sports Injury 7 Diversification • Pooling Similar Risks – INSURANCE • Pooling Offsetting Risks – A DIVERSIFIED PORTFOLIO 8 Why Reduce Uncertainty • Individual • Corporations • Government 9 Why Manage Risk? Individuals • Reduce anxiety • Planning 10 Why Manage Risks: Corporation (Nexus of Contracts) owners creditors employees Corporation suppliers government customers 11 Early Historical Examples of Risk Management • Chinese Trading Boats • Amish Rebuilding 12 Modern Risk Management • Prior to 1950s: Insurance Purchaser • Risk Managers – Finance Dept., Freestanding, or Human Resource Dept. – Larger Companies – Companies Facing Greater Risk 13 Risk Manager: Minimize Adverse Consequences of Risk • • • • • Avoidance Loss Control Self-Insurance Purchase Insurance Anticipate Risk 14 The Decision to Manufacture a Product 15 Product Development: Motorcycle • Investment: $1,000,000 • Profits if there is no Loss: $150,000 • Possible Liability Losses: – 1% Chance of $2,000,000 Loss • Required Return on Investment: 10% 16 Hiring an Employee 17 Hiring an Employee: Baseball Player with Drug Addiction • Salary: $200,000/year • Financial Contribution to Club – $300,000 if Says Clean – $50,000 if Uses Drugs – Chance of Staying Clean: 50% 18 Major Duties of Risk Managers • • • • • • • • • Buy Insurance Identify Risk Loss Prevention and Loss Control Contract Review Safety Training and Education Govt. Compliance with Safety Issues Risk Finance Claims Mgmt. and Litigation Support Employee Benefits 19 Risk Management Process • • • • Mission Identification Risk Identification Risk Analysis Consider Alternatives – Risk Control – Risk Finance • Implement and Monitor 20 Mission Identification • Goal of Organization • Goal of Risk Management Department 21 Organization Goals • Corporation: Maximize Profits • Non-Profit Organizations – Religious Organization – Hospitals 22 Organization Goals • Charities – Red Cross: The American Red Cross, a humanitarian organization led by volunteers, . . . will provide relief to victims of disasters and help people prevent, prepare for, and respond to emergencies. 23 Post-Loss Objectives • • • • • Survival of the Organization Continuity of Operations Earnings Stability Continued Growth Social Responsibility 24 Pre-Loss Objectives • Economy • Reduction in Anxiety – – – – – Owners Suppliers Lenders Customers Govt. Agencies • Meeting Externally Imposed Obligations • Social Responsibility 25 Risk Management Process Step 2 Risk Identification and Analysis 26 Risk Identification: Key Terms • • • • Hazard Risk Factor Peril Exposure 27 Difficulties with Risk Identification • New Laws – Examples: Building Codes, Clean Air Act • New Discoveries – Examples: Black Lung, Second Hand Smoke • Changing Societal Attitudes – Example: Product Liability Laws, Cigarettes 28 New Laws and Risk Identification 29 Sources of Risk • • • • • • • Physical Environment Social Environment Political Environment Legal Environment Operational Environment Economic Environment Cognitive Environment 30 Social Environment and Disney Co. • • • • Euro-Disney “Powder” Domestic Partner Benefits History Theme Park at Manassas 31 Example • Workplace Injury 32 Categories of Exposures • Property Exposures – Direct: Immediate Result – Indirect: Secondary Results – Example: Robbery of a Store • Liability Exposures • Human Resource Exposures 33 Risk Identification Methods 1 • • • • • Insurance Survey Risk Analysis Questionnaires Financial Statement Analysis Flow Chart Method Systems Safety Techniques 34 Risk Identification Methods 2 • • • • Interactions with External Resources Interactions with other Departments Past Losses On-Site Inspections 35 Accident Causation • Human Relations View • Engineering View 36 Loss Analysis Ratios • Severity = $Losses / # Losses • Frequency = # Losses / # Exposures • Expected Loss = $ Losses/ # Exposures 37 Ratios Example • Data – 1000 Restaurants – 50 Fires • Type 1 Fires: 20, $25,000 • Type 2 Fires: 30, $50,000 • Severity = [20($25,000) + 30($50,000)]/50 = $40,000 • Frequency = 50 / 1000 = .05 • Expected Loss = .05($40,000) = $2000 38 Concerns with Measuring Severity • Indirect Losses – Ex: Store robbery • Contagion – Ex: Foot-and-Mouth Disease • Snowball Effect – Ex: Mad Cow Disease 39 Contagion Example: Bil Mar 40 Contagion Example: Listeria • Chicago-based Sara Lee recalled hot dogs and deli meats produced at its Bil Mar plant in Zeeland, Michigan, after the CDC found listeria contamination in unopened packages of the products. • Affected brand names include Ball Park, Bil Mar, Sara Lee Deli Meat and Sara Lee Home Roast. • The states reporting listeria infections are Arizona, Connecticut, Georgia, Indiana, Iowa, Kentucky, Maryland, Massachusetts, Michigan, Minnesota, New York, Ohio, Oregon, Pennsylvania, Tennessee, Vermont and West Virginia. 41 Contagion Example: Listeria • Tainted meat – Killed 12 people – Sickened 79 others in 16 states • 241 workers fired or layed off 42 Loss Severity Measures • Maximum Possible Loss • Maximum Probable Loss 43 Example Year Flights Crashes 2003 2004 2005 2006 2007 5,000 5,000 5,000 5,000 5,000 10 0 4 2 0 Losses $2,000,000 0 $1,000,000 $500,000 0 44 Loss Statistics n Oi pi i1 freq mean = .2(.002)+.2(0)+.2(.0008)+.2(.0004)+.2(0) Mean = = .00064 sev mean = 10 (200,000) 6 (250,000) 16 16 = $218,750 E(L) = $140 45 Loss Statistics S.D. = Sev S.D. = n pi ( O i E V i ) 2 i1 (10)(200,000 218,750)2 16 ( 6 )(250,000 218,750)2 16 = $26,791 46 Normal Distn Severity Distance 1 S.D. 2 S.D. Prob 68.2% 95% $218,750 $191,959 $165,168 [ [ [ $245,541 $272,332 freq = .00064 sev = $272,332 E(L)95% = $174.29 47 Calculating the Mean and Std. Dev. Number of Fires Probability 0 10 30 50 60 .10 .20 .40 .20 .10 mean = .10(0)+.20(10)+.40(30)+.20(50)+.10(60) = 30 S.D. = sq. root [.10(0-30)(0-30) +.20(10-30)(10-30) +.40(30-30)(30-30) +.20(50-30)(50-30) +.10(60-30)(60-30)] = 18.43 48 Important Distributions • Loss Frequency Distribution • Loss Severity Distribution • Total Loss Distribution 49 Loss Frequency Distn Taxi Accidents N = 2000 Ot 0/2000 10/2000 30/2000 50/2000 60/2000 Pt .10 .20 .40 .20 .10 n E(Ot ) ptOt AvgFreq. t 1 0(.10) .005(.20) .015(.40) .025(.20) .03(.10) .015 .015(2000) = 30 Accidents 50 Loss Severity Distn N = 100 Sevt $1,000 $2,000 $10,000 $50,000 Pi .80 .05 .10 .05 n E(Sev ) (Sev )( pt ) i i1 i $1,000(.80) $2,000(.05) $10,000(.10) $50,000(.05) $4,400 51 Drawbacks to Use of Historical Data • CHANGE in Process • Insufficient Data 52 Importance of Timing of Losses • Time Value of Money • Cash Flow Considerations 53 Loss Triangles • Predict When Losses Will Occur • Predict Total Losses • Highlight Trends 54 Loss Triangle Product Liability Suits Loss Year Year of Experience (ex. Year of Sales) 2003 2004 2005 2006 2007 2003 12 2004 16 16 2008 = 15 x 1.337 = 20 2009 = 20 x 1.246 = 25 2005 20 21 9 2006 22 26 12 8 2007 22 29 15 11 15 2010 = 25 x 1.1075 = 28 2011 = 28 x 1 = 28 55 Development Factors Development Period Year of Experience 2003 2004 2005 2006 y+1 1.33 1.3125 1.33 1.375 y+2 1.25 1.238 1.25 y+3 1.10 1.115 y+4 1.00 MEAN 1.337 1.246 1.1075 1.000 Examples 2003, y+1 = 16/12 = 1.33 2003, y+2 = 20/16 = 1.25 56 Loss Development: 2007 Sales Year 2007: 15 Losses 2008: 2009: 2010: 2011: 15 x 1.337 20 x 1.246 25 x 1.107 28 x 1.000 = 20 = 25 = 28 = 28 57 Present Value Calculation Determining Losses from 2003 Sales Claim Made in Year 2003 2004 2005 2006 2007 2008 2009 Losses 2003 Sales i% 6% 6% 6% 6% 6% 6% 6% Total Cost/Claim PV in 2003 # Losses Losses $10,000 $12,000 $14,000 $15,000 $18,000 $20,000 $24,000 $10,000 $11,321 $12,460 $12,594 $14,258 12 4 4 2 0 $120,000 $45,284 $49,840 $25,188 0 $240,312 58 Homework Problems • A) Determine the Number of Fully Developed Losses for 2004, 2005, and 2006. • B) What is the PV of Losses Arising from 2005 Sales as of 2005? 59 Shapes of Different Distributions • Medical Expenditures • Church Fires • Parking Tickets 60 Normal Distribution • Bell Shaped • Two Parameters • Easy to Use 61 Property Losses • Property Exposed to Loss • Peril • Financial Consequences 62 Property Exposed to Loss [ Real Property [ Personal Property [ Non-owned Property 63 Non-owned Property • • • • • • • Bailed Property Leased Property Property on Consignment Employee’s Property Property under Lien Agency Relationships Contingent Property 64 Perils • Commonly Insured • Government Insured • Uninsurable 65 Commonly Insured Perils 1 • • • • • • Fire Lightning Windstorm Hail Explosion Smoke 66 Commonly Insured Perils 2 • • • • • • • • • • Aircraft & Vehicle Damage Riot Vandalism (Malicious Mischief) Falling Objects Weight of Snow, Ice, or Sleet Water Damage Glass Breakage Sprinkler Leakage Perils of Transportation Crime Perils 67 Difficult to Insure Perils • Earth Movement • Floods • Nuclear Reaction 68 Why Are Some Perils Uninsurable? • Against Public Policy • Under the Control of the Insured – Ex. Suicide • Probability of Loss is Too High • Simultaneous Destruction 69 Generally Uninsurable Perils • War, Terrorism, Rebellion, and Insurrection • Intentional Losses • Fading, Rust, Dry Rot, Settling • Production, Marketing, and Political Risks 70 Financial Consequences • • • • • • • • • • Reduction in Value Debris Removal Business Interruption Contingent Business Interruption Loss of Rental Income Loss of Rental Value Loss of Leasehold Interest Inability to Reconstruct Records Loss of Use Value in Improvements and Betterments Demolition Costs and Increased Cost of Reconstruction 71 Valuation of a Loss • Market Value • Replacement Cost • Actual Cash Value – (Replacement Cost - Depreciation) • Present Value of the Asset’s Contribution 72 Actual Cash Value Calculation: Building • Purchase – Date: January 1, 1987 – Price: $1,000,000 – Expected Lifetime: 40 years • Fire – Date: January 1, 2007 – Replacement Cost: $2,000,000 73 Actual Cash Value Calculation: Building • ACV = Replacement Cost - Depreciation –As of the Time of Loss • ACV = $1,000,000 = $2,000,000 - $1,000,000 74 Present Value of the Asset’s Contribution 75 Liability Loss • Expenditure of TIME and MONEY • Investigate, Negotiate, Defense, Payment 76 Property Losses v. Liability Losses • Parties Involved • Measurement of Exposure • Changing Environment • Tail 77 Types of Legal Liability • Criminal – Agent – Punishments – Insurance • Civil – Private Duties – Common Law, Statutes, Contracts 78 TORT • Wrongful Act or Omission • Independent of Contract • Legal Remedy: DAMAGES ($$$) 79 Types of TORTS • Intentional Torts • Negligence • Strict Liability 80 Intentional TORTS • Legally Protected Right • Intentional Interference – Voluntary – Damages Reasonably Foreseen – No Valid Defense 81 Intentional Torts: Defamation • Types – Libel – Slander • Plaintiff Must Show – False, Injurious Statement – Publication – Damages 82 Defenses • Truth • Privilege – Absolute – Qualified • • • • • No Malice Not Known False No Intent to Injure Fair, if by news media Covered Body 83 Intentional Torts: Invasion of the Right of Privacy • Examples – Release Confidential Information – Hidden Microphones • Public Figures v. Private Figures 84 Intentional Torts: Assault and Battery • Assault • Battery • Defenses – – – – – Consent Self-Defense Defense of Property Defense of Others Allowed Discipline 85 The “Preppy Killer”: Consent?? 'Preppie killer' headed back to prison on drug rap NEW YORK (AP) -- New York's so-called "preppie killer" is headed back to prison. Robert Chambers already served 15 years behind bars for strangling a woman in Central Park during what he said was rough sex. He pleaded guilty Monday to selling drugs. The Manhattan district attorney's office says Chambers is promised 19 years and four months in prison when he is sentenced on September 2. Chambers and his girlfriend were charged with dealing cocaine out of their Manhattan apartment in 2007. Chambers pleaded guilty in 1988 to manslaughter in the death of 18-year-old Jennifer Levin two years earlier. Stories portrayed him as a handsome, privileged, prep school youth gone bad. He was released from prison in 2003. 86 Intentional Torts: Assorted Others • False Arrest and Wrongful Detention • Malicious Prosecution • Trespass • Conversion • Nuisance 87 Intentional Torts: Assorted Others Continued • Wrongful Interference with a Business Relationship – Copyright Infringement – Deception • Bad Faith – Delaying Payment of Claims – Refusing to Pay Claims 88 Negligence • Acts of Omission • Acts of Commission 89 Elements of a Negligent Act • Legal Duty • Breach • Damages • Proximate Cause 90 Damages • Compensatory Damages – Special Damages – General Damages • Punitive Damages 91 Defenses to Negligence • • • • • Contributory Negligence Comparative Negligence Assumption of Risk Statute of Limitations Immunities – Sovereign – Charitable Institutions – Public Officials 92 Strict Liability Torts • Abnormally Dangerous Instrumentalities • Ultrahazardous Activities • Dangerously Defective Products • Workers Compensation Statutes • Disability Benefit Statutes • Aviation Law • Dram Shop Laws • Contractual Assumptions 93 Goals of the Tort System • Compensate • Deter 94 Tort Reform Proposals • Modify Joint and Several Liability • Caps on Non-Economic Damages • Caps on Punitive Damages 95 The Work Relationship • Employer – Sets Hours – Defines and Supervises Work • Employee – Sacrifices Time for Income – Is Told How to Work – Method of Payment Not Important to Status • Independent Contractor – Not an Employee – Controls Methods of Work 96 Workplace Injuries • Common Law: Negligence • Statutory Law: Workers Compensation 97 America’s Most Dangerous Jobs in 2004 Rank Occupation Death rate/100,000 Total deaths 1 Logging workers 92.4 85 2 Aircraft pilots 92.4 109 3 Fishers and fishing workers 86.4 38 4 Structural iron and steel workers 47.0 31 5 Refuse and recyclable material collectors 43.2 35 6 Farmers and ranchers 37.5 307 7 Roofers 34.9 94 8 Electrical power line installers/repairers 30.0 36 9 Driver/sales workers and truck drivers 27.6 905 10 Taxi drivers and chauffeurs 24.2 67 98 Some Exceptions to Workers Compensation • Small Firms • Farm Workers • Domestic Workers 99 Employers’ Common Law Duties • Safe Place to Work • Adequate Number of Competent Fellow Employees • Provide Safe Tools and Equipment • Warn of Inherent Dangers • Make and Enforce Safety Rules 100 Workers Compensation • Accident • Arising Out of and In the Course of Employment • Only Bodily Injury 101 Workers Compensation Benefits • Lost Wages • Medical Care • Body Part Payments • Death Benefits 102 Exceptions to WC as Sole Remedy for Workplace Injury • • • • Assault by the Employer Retaliatory Discharge of the Employee Dual Capacity Doctrine Suits by 3rd Parties – Ex. Loss of Consortium – Ex. Consequential Injuries • Property Damage 103 Human Resource Exposures • Loss of Personnel • Cost of Employee Benefits 104 Employee Benefits • Attract Workers • Retain Workers • Retire Workers • Encourage Productivity 105 Loss of Personnel • Premature Death • Disability/Poor Health • Resign 106 Premature Death Losses that Result • Loss of Human Life Value • End of Life Expenses • Emotional Grief of Survivors 107 Premature Death Risk Management Strategies • Loss Prevention: – Medical Care – Good Health • Life Insurance: Many are Underinsured • Pension Plan • Earnings of Surviving Spouse 108 Estimating Human Life Value Example: Worker 3 years from Retirement Year Output Pay 2004 2005 2006 50000 49000 48000 40000 38000 36000 TOTAL Surplus PV(8%) 10000 11000 12000 10000 10185 10288 30473 109 Calculating Loss of Human Life Value Worker dies at age 61 after being paid. At the time of death 3 working years remained. Age 62 63 64 Total Earnings Taxes $40,000 $40,000 $40,000 $16,000 $16,000 $16,000 Self Family PV(8%) $10,000 $14,000 $10,000 $14,000 $10,000 $14,000 $14,000 $12,963 $12,003 $38,966 110 Disability Problem • Disability is comparatively frequent • Disability can be extremely costly • Most lost income due to disability is not replaced • Disability insurance is confusing – Multiple definitions of disability • Disability insurance is subject to moral hazard – Malingering 111 Risk of a 90+ Day Disability v. Death During Working Years Age 22 62 P(Disability)/P(Death) 7.5 2 112 Risk Control • • • • • Avoidance Prevention Reduction Information Management Some Risk Transfers 113 Risk Avoidance • Proactive Avoidance • Abandonment 114 Drawbacks to Avoidance • Lost Benefits of Risk • Perhaps not Possible $ Government Imposed Risks $ Nature of the Risk • May Result in Worse Risks 115 Important Forms of Loss Reduction Salvage Subrogation Litigation Management Catastrophe (or Contingency) Plans Duplication Separation 116 Information Management as Loss Control • • • • Customers: Enhanced Sales Creditors: Lower Debt Cost Suppliers: Better Relationships Owners: Greater Market Value 117 Risk Transfer • Property or Activity Transferred • Contractually Pass the Liability “Exculpatory Contracts” 118 Government and Risk Control • Public Interest • Efficiency 119 Risk Financing: General Methods • Retention • Transfer 120 Risk Financing: Timing • Contemporaneous • Prospective • Retrospective 121 Approaches to Retention Passive or Unplanned Active or Planned 122 Retention: Funding Arrangements • No Advance Funding • Liability or Earmarked Accounts • Earmarked Asset Accounts • Captive Insurer 123 Types of Transfers • Insurance • Noninsurance Transfers • Hedging 124 Elements of Insurance • Contract • Premium • Conditional Benefits • Pooling of Resources 125 Insurance Transaction • Buyer Side of the Market – Risk Managers – Brokers – Consultants • Supplier Side of the Market – Insurance Company • Underwriters, Claims Adjusters, Agent, Actuaries – Agent 126 Noninsurance Transfers • Do Not Satisfy Conditions to be Insurance • Provide External Funding 127 Hedging • Taking an Offsetting Risk • Not Possible for Many Types of Risks 128 129 130 131 Hedging Example January 1: Arrange to sell chairs for $5.00 Raw materials today cost $2.50/chair June 1: Build chairs July 1: Deliver chairs 132 Hedging Example Risk: Cost of raw materials Options: 1. Sell chairs on a cost + basis 2. Buy and hold raw materials 3. Buy and have seller hold raw materials 4. Use a hedge 133 “Futures” Contract Owner of contract on Termination Date Receives the lumber Price of contract depends on a) Cost of lumber today b) Risk Premium Origination Date: September 1 Termination Date: August 31. 134 Hedging Contract January 1: June 1: Buy Hedging Contract Hedging Contract = $2.50 + x Lumber = $2.50 Risk Premium = x Buy Lumber & Sell Futures Contract Lumber = $2.50 + y Futures Contract = $2.50 + (x - z) + y Change in lumber cost = y Depreciation of risk premium = z Total Cost = ($2.50 + x) + ($2.50 + y) - ($2.50 + (x - z) + y) = $2.50 + z 135 Hedging Contract Numerical Example Origination Date: September 1 Termination Date: August 31. Original Risk Loading: 0.60 x = .40 x decreases .05 per month z = .05(5) = .25 Total Cost = $2.50 + .25 = $2.75 136 Hedging Instruments for Financial Risks 137 Hedging Volatility • Volatility is a measure of risk • Some sources of volatility can be hedged – Interest Rate – Exchange Rate – Commodity Price 138 Interest Rate Volatility • Debt is a key component of a firm’s capital structure • Interest rate hedges can stabilize borrowing costs • Some tools: forwards, futures, swaps, options 139 Exchange Rate Volatility • International businesses are exposed to exchange rate risk • Tools for managing exchange rate risk – forwards – futures – swaps 140 Commodity Price Volatility • Costs of materials can be volatile: – Pricing becomes problematic – Sales demand becomes harder to predict • Hedging allows for: – Better production decisions – Reduced volatility in cash flows • Available tools (depending on the type of commodity): – – – – Forwards Futures Swaps Options 141 Reducing Risk Exposure • Hedging will not normally reduce risk completely – Typically, only price risk can be hedged not quantity risk – Reducing risk completely causes loss of potential upside • Timing – Short-run exposure can be managed in a variety of ways – Long-run exposure almost impossible to hedge 142 Forward Contracts • A contract between parties – Agreement today on the price of the asset on the delivery date – Delivery and payment is specified for a future date • Forward contracts are legally binding on both parties • Positions – Long: – Short: Agrees to buy the asset on the future date Agrees to sell the asset on the future date • Key points – Negotiated contract – No exchange of cash initially – Usually limited to large, creditworthy corporations 143 Payoffs on Forward Contracts 144 Hedging with Forwards • Forward contracts can virtually eliminate price risk • New risk created: Credit risk of the counterparty • Forward contracts are primarily used to hedge exchange rate risk 145 Futures Contracts • Futures traded on organized securities exchanges • Upfront cash payment: MARGIN – Small relative to the value of the contract – “Marked-to-market” on a daily basis • Clearinghouse guarantees contract performance • Clearinghouse and margin requirements virtually eliminate credit risk 146 Hedging with Futures • Futures contracts are standardized – Allows for trading – Exact hedging may be difficult or impossible • Credit risk is virtually nonexistent • Futures contracts are available on – – – – physical assets debt contracts Currencies equities 147 Swaps • A long-term agreement between two parties • Can be viewed as a series of forward contracts • Generally limited to large creditworthy institutions or companies 148 Option Contracts • The right, but not the obligation, to buy (sell) an asset for a set price on or before a specified date – – – – • Call – right to buy the asset Put – right to sell the asset Exercise or strike price –specified price Expiration date – specified date Buyer has the right to exercise the option; the seller is obligated – Call – option writer is obligated to sell the asset if the option is exercised – Put – option writer is obligated to buy the asset if the option is exercised • Options allow a firm to hedge downside risk, but still participate in upside potential • Pay a premium for this benefit 149 Buy a call with E = $40 Sell a Call E = $40 70 0 60 -10 0 50 -20 40 Payoff Payoff Payoff Profiles: Calls 30 20 20 40 60 80 100 -30 -40 -50 10 -60 0 0 20 40 60 Stock Price 80 100 -70 Stock Price 150 Payoff Profiles: Puts 45 40 35 30 25 20 15 10 5 0 Sell a Put E = $40 0 -5 0 -10 20 40 60 80 100 -15 Payoff Payoff Buy a put with E = $40 -20 -25 -30 -35 -40 0 20 40 60 Stock Price 80 100 -45 Stock Price 151 Retention vs. Transfer • • • • • • • • Ability to Bear the Loss Cost and Effectiveness of a Transfer Degree of Control over the Risk Insurance Loading Fees Additional Insurer Services Insurance as a Signal Opportunity Costs Taxes 152 Risk Financing Methods • Guaranteed Cost Insurance • Experience-Rated Insurance • Retrospective Rating 153 Guaranteed Cost Insurance Underwriting Premium Depends on Classification Group Premium = (A)* (PURE PREMIUM) + B 154 Pure Premium # cars = 10,000 # losses = 250 $ losses = $4.5 million Pure Premium = frequency x severity Frequency = 250 / 10,000 = 2.5% Severity = $4.5 million / 250 = $18,000 Pure Premium = 2.5% (18,000) = $450 A = 1.4 B = $50 1.4 (450) + 50 = $680 155 Underwriting Considerations • • • • • • Adverse Selection Misclassification Control Civil Rights Costs of Classification Social Policy 156 What’s Fair and Why Health Insurance Underwriting Factors • • • • • • • Cigarette Smoking Obesity Age Prior history of heart disease Genetic Predisposition to Stomach Cancer Gender Race 157 State Underwriting Restrictions: Health Insurance • CALIFORNIA: Blindness, Gender, Marital Status, DES • N. DAKOTA: Blindness, Gender, Race • WISCONSIN: Blindness, Gender, Physical Impairment 158 How Insurance Works An Example Assume an individual has a 1% probability of getting cancer and incurring medical expenses of $200,000. How much would you charge to bear this risk? 159 How Insurance Works Central Limit Theorem Mean = True Mean Law of Large Numbers Increase sample size by N New Mean = Old Mean x N New S.D. = Old S.D. x Sq. Root of N 160 HOW INSURANCE WORKS AN ILLUSTRATIVE EXAMPLE Sample Size = 1,000 Mean = 10 S.D. = 2 Loss per claim = $200,000 4 6 8 10 12 14 S.D. Prob. 1 68.27 2 95.45 3 99.73 16 161 HOW INSURANCE WORKS AN ILLUSTRATIVE EXAMPLE For 99.73% survival prob. insurer will charge: 16 x $200,000 = $3,200 1,000 Increase sample size to 100,000 (100x) Mean # of Losses = 10 x 100 = 1,000 S.D. = 2 x sqroot (100) = 20 Now for 99.73% survival prob. insurer will charge: 1060 x $200,000 = $2,120 100,000 162 Requirements of an Insurable Risk 1. 2. 3. 4. 5. Large Number of Homogenous Exposure Units Accidental Determinable and Measurable No Simultaneous Destruction Probability Calculable and Not Too High suicide, space shuttle, mental illness, war, early flight and computers, terminally ill 163 Social and Economic Value of Insurance • • • • • • Stability Indemnification Reduction in Reserve Funds Insurers’ Ability to Invest Satisfies Financial Requirements Specialization in Loss Prevention 164 Social Costs of Insurance • Insurers’ Operating Costs • Moral Hazard • Exaggeration of Losses 165 Cheating with Insurance • Insurer – – – – Failure to Honor the Contract Misleading Contracts False Advertising Inappropriate Sales • Insured – Fraud 166 Controlling Cheating • Litigation • Regulation 167 Litigation Requirements of an Insurable Contract • Offer and Acceptance • Consideration • Competent Parties • Legal Purpose 168 Litigation Legal Principles: Indemnity • Valuation – Property: ACV – Liability: Actual Damages • Apparent Exceptions – Valued Policies – Replacement Cost Insurance – Life Insurance 169 Actual Cash Value Example ACV = Replacement Cost – Depreciation 1/1/04: Buy Machine for $3,000, 10 year life 1/1/06: Fire Destroys Machine; New Machine Costs $10,000 ACV = $10,000 - $2,000 = $8,000 170 Litigation Principle of Insurable Interest • Property and Liability: Time of Loss – Ownership – Potential Legal Liability – Secured Creditors • Life Insurance: Time of Policy Purchase – Close Ties: Love, Blood, Marriage – Pecuniary Interest 171 Litigation Principle of Subrogation • Prevents Double Indemnification • Holds Down Insurance Costs 172 Litigation Principle of Utmost Good Faith • Representations • Concealment • Warranty Is It Material? 173 Why Is Insurance Regulated? • Advance Payment of Premiums • Complexity of Transaction 174 Types of Regulation • • • • • Licensing Solvency Rate Approval Agents’ Activities Insurance Contracts 175 Insolvency: Major Reasons • • • • • • Bad Management Poor Underwriting Inadequate Reserves Bad Investing Inattentive to Loss Prevention Competitive Pressures 176 Danger of Insolvency • Most Insurers are Very Solid • 100+ Years – 71 Life Insurers – 200 Property and Liability Insurers • Guaranty Funds • Buyout of Failing Firms 177 Premium Regulation • Adequate • Fair • Reasonable 178 Methods of Rate Regulation • Prior Approval • File and Use • Open Competition 179 Advantages of Open Competition • • • • Flexibility Increased Availability of Insurance Avoid Political Fights Frees Time of Regulators 180 Disadvantages of Open Competition • Price Gouging (?) • Risk of Insolvency (?) • Fair (?) 181 Regulation of Agents’ Activities • Licensing • Prohibited Acts – Twisting – Rebating 182 Causes of Insurance Market Failure • Adverse Selection • Individuals Underestimate the Loss Potential • Insurance Costs Too Much • Pooling Not Possible • Insurers Can Not Estimate the Loss Potential 183 THE END 184
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