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INFORM+INSPIRE. Risk Management Principles and T he Role of Insurance. David T. Russell, Ph.D. Director, CSUN Center for Risk and Insurance March 14-15, 2013. What is Risk?. In short, Risk = Uncertainty Two Kinds of Risk Pure Risk: Possibility of Loss

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risk management principles and t he role of insurance

INFORM+INSPIRE

Risk Management Principles andThe Role of Insurance

David T. Russell, Ph.D.

Director, CSUN Center for Risk and Insurance

March 14-15, 2013

The Griffith Insurance Education Foundation

what is risk
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

The Griffith Insurance Education Foundation

risk management
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

The Griffith Insurance Education Foundation

insurance
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

The Griffith Insurance Education Foundation

the insurance purchase decision
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

The Griffith Insurance Education Foundation

insurance is not gambling
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

The Griffith Insurance Education Foundation

underwriting
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

The Griffith Insurance Education Foundation

moral hazard
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

The Griffith Insurance Education Foundation

adverse selection
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

The Griffith Insurance Education Foundation

the insurance mechanism
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”

The Griffith Insurance Education Foundation

insurable risks
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

The Griffith Insurance Education Foundation

the insurance mechanism1
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

The Griffith Insurance Education Foundation

simplified pricing example
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)

The Griffith Insurance Education Foundation

other pricing considerations
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

The Griffith Insurance Education Foundation

rate regulation
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

The Griffith Insurance Education Foundation

rate regulation1
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

The Griffith Insurance Education Foundation

solvency surveillance
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

The Griffith Insurance Education Foundation

solvency surveillance what can go wrong
Solvency Surveillance:What Can Go Wrong?

Note: Insurance companies use different, more “stable” accounting rules called Statutory Accounting.

The Griffith Insurance Education Foundation

us insurance market
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

The Griffith Insurance Education Foundation

slide20

Source: SNL Financial, Inc.

The Griffith Insurance Education Foundation

2011 p c u s npw by line
2011 P&C U.S. NPW by Line

The Griffith Insurance Education Foundation

2011 life a h npw by line
2011 Life/A&H NPW by Line

The Griffith Insurance Education Foundation

the california insurance market
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

The Griffith Insurance Education Foundation

policy forms
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.

The Griffith Insurance Education Foundation

policy forms1
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

The Griffith Insurance Education Foundation

any questions

INFORM+INSPIRE

Any Questions?

Feel free to contact me:

David T. Russell, Ph.D.

California State University, Northridge

(818) 677-2438

David.Russell@csun.edu

The Griffith Insurance Education Foundation