Risk Management Principles and T he Role of Insurance

1. 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

2. 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

3. 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

4. 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

5. 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

6. 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

7. 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

8. 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

9. 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

10. 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

11. 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

12. 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

13. 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

14. 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

15. 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

16. 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

17. 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

18. Solvency Surveillance:What Can Go Wrong? Note: Insurance companies use different, more “stable” accounting rules called Statutory Accounting. The Griffith Insurance Education Foundation

19. 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

20. Source: SNL Financial, Inc. The Griffith Insurance Education Foundation

21. 2011 P&C U.S. NPW by Line The Griffith Insurance Education Foundation

22. 2011 Life/A&H NPW by Line The Griffith Insurance Education Foundation

23. 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

24. 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

25. 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

26. 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