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INFORM+INSPIRE. Risk Management Principles and The Role of Insurance. Washington, D.C. April 29 th , 2013 James M. Carson, Ph.D. CPCU, CLU, ARM The University of Georgia. Risk. Focus on Fundamentals Some review of familiar terms / concepts likely (see materials)

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risk management principles and the role of insurance

INFORM+INSPIRE

Risk Management Principles and The Role of Insurance

Washington, D.C.

April 29th, 2013

James M. Carson, Ph.D. CPCU, CLU, ARM

The University of Georgia

The Griffith Insurance Education Foundation

slide2
Risk
  • Focus on Fundamentals
    • Some review of familiar terms / concepts likely (see materials)
    • Plus some new thoughts / concepts
  • Comments / Questions Welcome

The Griffith Insurance Education Foundation

risk is ubiquitous
Risk is Ubiquitous
  • Personal/Individual
  • Family
  • Business
  • Government

The Griffith Insurance Education Foundation

risk risk
Risk Risk

The Griffith Insurance Education Foundation

top 16 most costly disasters in u s history
Top 16 Most Costly Disastersin U.S. History

(Insured Losses, 2012 Dollars, $ Billions)

Hurricane Sandy could become the 4th or 5thcostliest event in US insurance history

Includes Joplin, MO, tornado

Includes Tuscaloosa, AL, tornado

12 of the 16 Most Expensive Events in US History Have Occurred Over the Past Decade

Hurricane Irene became the 12th most expense hurricane in US history in 2011

The Griffith Insurance Education Foundation

Insurance Information Institute.

us insured catastrophe losses
US Insured Catastrophe Losses

$100 Billion CAT Year is Coming Eventually

($ Billions)

2000s: A Decade of Disaster

2000s: $193B (up 117%)

1990s: $89B

Record Tornado Losses Caused 2011 CAT Losses to Surge

2011 was one of the Most Expensive Year in History for Insured Catastrophe Losses in the US

*Estimate through Oct. 31, 2011.

Note: 2001 figure includes $20.3B for 9/11 losses reported through 12/31/01. Includes only business and personal property claims, business interruption and auto claims. Non-prop/BI losses = $12.2B.

Sources: Property Claims Service/ISO; Insurance Information Institute.

The Griffith Insurance Education Foundation

6

12/01/09 - 9pm

eSlide – P6466 – The Financial Crisis and the Future of the P/C

underwriting gain loss 1975 2012 q3
Underwriting Gain (Loss)1975–2012:Q3*

($ Billions)

Underwriting losses through 2012:Q3 totaled $6.7B

Cumulative underwriting deficit from 1975 through 2011 is $479B

High cat losses in 2011 led to the highest underwriting loss since 2002

Large Underwriting Losses Are NOT Sustainable in Current Investment Environment

The Griffith Insurance Education Foundation

* Includes mortgage and financial guaranty insurers in all years.

Sources: A.M. Best, ISO; Insurance Information Institute.

what is risk
What is Risk?
  • Traditional Definition
    • Risk = Uncertainty
      • Risk of Death?

The Griffith Insurance Education Foundation

what is risk1
What is Risk?
  • A Better Definition
    • Risk = Uncertainty about chance, timing, or amount of loss
      • Risk of ____ death
      • Risk of poor health
      • Risk of car accident
      • Risk of house fire
      • Etc…….

The Griffith Insurance Education Foundation

types of risk
Types of Risk
  • Objective risk v. Subjective risk
  • Pure risk v. Speculative risk
  • Property risk (direct v. indirect)
  • Liability risk
    • (Ex: Corps of Engineers, Deepwater Horizon Spill)

The Griffith Insurance Education Foundation

the burden cost of risk on society
The Burden / Cost of Risk on Society
  • Need for Emergency Funds
  • Outlays to Reduce Risk
  • Opportunity Cost
  • Expense of Financing Potential / Actual Losses
  • Increased Prices
  • Loss of Certain Goods & Services
  • Worry and Fear
  • Time
  • Losses For Which We Are Not Indemnified

The Griffith Insurance Education Foundation

benefits of managing risk
Benefits of Managing Risk
  • Potential Enhancement of Credit
  • Indemnification for Losses
  • Less Worry and Fear—More Activity
  • Source of Investment Funds
    • (~$6 T Assets)
  • Loss Prevention Services
    • Private Efforts
    • Public Efforts (Ex: flood mitigation)

The Griffith Insurance Education Foundation

risk management
Risk Management

The Griffith Insurance Education Foundation

risk management1
Risk Management
  • Definition:
    • Formal decision-making process to identify risk and minimize the cost of risk, including the potential financial consequences associated with loss exposures

The Griffith Insurance Education Foundation

risk management process
Risk Management Process
    • Identify loss exposures and select the most appropriate techniques for treating such exposures
      • Broader than simply Insurance
      • Trend toward “Enterprise Risk Management”
  • Loss Exposure:
    • Any asset exposed to loss; any situation in which a loss may occur

The Griffith Insurance Education Foundation

slide16

Risk Management Process

Identify

Evaluate

Select a Technique

Avoid

Retain

Transfer

Control

Insurance

Other

Contractual

Implement and Monitor

The Griffith Insurance Education Foundation

evaluating loss exposures
Evaluating Loss Exposures
  • Loss Frequency
    • Car accident occurs every 5 _____ in U.S.
      • For most drivers, though, low frequency, 1 in 10 years
  • Loss Severity
    • Maximum Probable Loss
    • Maximum Possible Loss

The Griffith Insurance Education Foundation

select appropriate technique the risk management matrix

Frequency

High

Low

High

Severity

Low

Select Appropriate Technique: The Risk Management Matrix

Avoid

Insurance

Retain

Control/Retain

The Griffith Insurance Education Foundation

select an appropriate technique
Select an Appropriate Technique
  • Retention
    • Why would you/someone/firm retain risk?
    • How Much Can be Retained?
    • (Financial Capacity)
    • Active vs. Passive
    • Retention vs. Self-Insurance (Formal)
    • Disadvantages

The Griffith Insurance Education Foundation

the insurance mechanism
The Insurance Mechanism
  • Definition:
    • The pooling of fortuitous losses
    • By transfer of risks to insurer
    • Insurer agrees to indemnify for covered losses

The Griffith Insurance Education Foundation

basic elements of insurance
Basic Elements of Insurance
  • Pooling of losses
    • Losses are shared by the pool
    • Substitutes average loss ($xxx) for actual loss ($30,000 car)

The Griffith Insurance Education Foundation

basic elements of insurance1
Basic Elements of Insurance
  • Replaces uncertain loss (risk) with certain payment (premium)
  • Unique in that pricing before the fact—don’t really know costs until after product is sold
  • Insurer uses law of large numbers and past experience to estimate premiums

The Griffith Insurance Education Foundation

pricing of insurance an analogy
Pricing of Insurance – An Analogy
  • Substitutes average loss ($607) for actual loss

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insurance prices rates
Insurance Prices (Rates)
  • Objectives: Adequate, not excessive, not unfairly discriminatory
    • Conflicts among these goals

The Griffith Insurance Education Foundation

insurance prices rates1
Insurance Prices (Rates)
  • Methods vary by state and line of business
    • Personal lines generally are more strictly regulated than commercial lines
    • Often more concerned with rates that are too low rather than too high
        • Remaining insurers pay claims of failed insurers

The Griffith Insurance Education Foundation

basic elements of insurance2
Basic Elements of Insurance…
  • Surplus
    • Insurer “Net Worth” = Owners’ Equity = A – L
    • For U.S. P-C Insurance Industry, ~$600 B
    • If, at end of the year (policy period):
      • Losses > expected, fund balance (“Surplus”) goes down
      • Losses < expected, fund balance (“Surplus”) goes up

The Griffith Insurance Education Foundation

basic elements of insurance3
Basic Elements of Insurance
  • “Surplus” is the Insurance Mechanism’s “Cushion” and is what enables insurers to offer insurance
  • Premium / Surplus ratio concept (leverage)

The Griffith Insurance Education Foundation

requirements of an insurable risk
‘Requirements’ of an Insurable Risk
  • Large Number of Homogeneous Exposure Units
  • Accidental and Unintentional Loss
  • Determinable and Measurable Loss
  • Calculable Chance of Loss
  • Economically Feasible Premium
    • If calculated premium is too high, probably
    • trying to insure something that is best _______
  • Best suited for risks that have __S and __F

The Griffith Insurance Education Foundation

adverse selection
Adverse Selection
  • Definition:
    • Phenomenon whereby people with higher-than-average chance of loss are more likely to seek insurance than average risks (e.g., ……)
    • i.e., the non-face cards don’t buy insurance, then the pool doesn’t collect $607 * 36

The Griffith Insurance Education Foundation

adverse selection1
Adverse Selection
  • Consequences
    • Results in higher losses & expenses than expected
    • Prices increase
    • “Better” risks drop out of pool, prices increase….
      • ”Death Spiral”

The Griffith Insurance Education Foundation

controlling adverse selection
Controlling Adverse Selection
  • Underwriting
    • Involves selecting and classifying insurance applicants
    • Certain standards that must be met for “standard” rates
    • If better than “standard,” lower rate applies
    • If < “standard,” higher rate applies
  • Policy Provisions
    • E.g., Suicide clause in life insurance

The Griffith Insurance Education Foundation

key points about adverse selection
Key Points about Adverse Selection
  • Risk pooling doesn’t work if the risk is too high
  • Risk pooling doesn’t work with too many high risks
  • Insurers need to be able to identify risk type so that they can put similar risks together in a pool to make it fair and affordable
    • Competition will drive premiums to the appropriate level for risk type

The Griffith Insurance Education Foundation

the moral hazard problem
The “Moral Hazard” Problem
  • Definition: Behavior change due to the presence of insurance that increase the frequency or severity of loss
  • Examples:
    • Faking accidents, disability
    • Exaggeration of claims
    • Failure to control losses (not locking car or house)
    • Intentional losses
    • Overutilization of insurance (e.g. health)

The Griffith Insurance Education Foundation

controls on moral hazard
Controls on Moral Hazard
  • Can’t insure in excess of the loss
  • Limits on underinsuring property
  • Careful claims adjusting
  • Deductibles and coinsurance
  • Waiting periods
  • Exclusions
  • Limits
  • Riders

The Griffith Insurance Education Foundation

societal costs of insurance
Societal Costs of Insurance
  • Cost of Claims
  • Outlays to Reduce Risk (Loss Control)
  • Increased moral hazard
    • Changes in behavior

The Griffith Insurance Education Foundation

societal costs of insurance1
Societal Costs of Insurance…..
  • Cost of Ins. Mechanism --“Expense Load”
    • Cost (Expenses, Profits, Contingencies), including Inflated / Fraudulent Claims
      • Insurers do not “pay” claims We pay claims
      • Anything that increases outflow must have an inflow
    • EX: To insure expected losses of $5,000 would require premium of more than $5,000; so, for example, $5,000 + ~20% = ~$6,000

The Griffith Insurance Education Foundation

brief overview of basel 3
Brief overview of Basel 3
  • Capital standards
    • Primarily geared toward banks
    • Gets applied to some insurers via Dodd-Frank Act

The Griffith Insurance Education Foundation

basel 3 cont
Basel 3 cont…
  • Authorizes Federal Reserve Board regulation of
    • Savings and Loan Holding Companies (some of which own life insurers)
    • Nonbank Financial Companies (may include insurers that are deemed systemically important by the Financial Stability Oversight Council)

The Griffith Insurance Education Foundation

basel 3 cont1
Basel 3 cont…
  • Some Issues
    • Risk-Based Capital (RBC) and FAST exist for insurers
    • Long-term Assets vs. Short-term Assets
    • Bank-type regulation at federal level vs. insurer-type regulation at state level

The Griffith Insurance Education Foundation

risk management principles and the role of insurance1

INFORM+INSPIRE

Risk Management Principles and The Role of Insurance

Thank you.

For more information contact:

The Griffith Insurance Education Foundation

7100 North High Street, Suite 200

Worthington, Ohio 43085

Phone: 855-288-7743

Email: info@griffithfoundation.org

To download today’s presentation, please visit www.griffithfoundation.org/resources

The Griffith Insurance Education Foundation