Exam 1 Flashcards
Pure Risk
-Uncertainty
-Focus of Traditional Risk Management
-Losses can be known with certainty
Impossible loss has 0% chance of happening
-No Risk Present/No uncertainty: budget and plan to avoid the loss
-Loss is still present, no uncertainty about loss
-Risk does not equal loss
Probability of a Loss
- chance of a loss
- probability ranges from 0-1, or 0%-100%
- Risk does equal probability of a loss
Pure Vs. Speculative Risk
- Both involve uncertainty
- Difference is in outcomes
- Risk does not equal probability of a loss
Speculative Risk
-3 future states
1. Gain
2. Loss
3. Break Even
Basis for Enterprise Risk Management (ERM)
Pure Risk
2 Future States
- Loss
- No Loss
- fire, flood, death, sickness
Static Risk
- Does not change significantly over time
- Always present
Dynamic Risk
-Arises out of changing circumstance
Subjective Risk
- An individual’s view of uncertainty or the situation involving risk
- Depends on the individual’s attitude toward risk
- Not easily measured
- Not easy to compare
- Influence how a firm or decision maker will handle risky situations
Objective Risk
- Risk is uncertainty concerning a loss
- Variation is key; variation of actual outcomes around or about expected outcomes
- Expected Loss (EL) - based on experience, data or other means, what we expect to happen
- Actual Loss (AL) - Losses that actually occur
Sources of Pure Risk
- Human Capitol
- Retirement/Unemployment
- Property/Liability
- Wealth Losses
Human Capitol
- Personal Pure Risk
- Ability to generate income
Retirement/Unemployment
- loss or reduction in income
- possible higher medical expenses
Property/Liability
-ownership of financial or physical assets
-theft, damage - property pure risk
Direct Loss - cost of replacing the asset, cost of repair
Indirect Losses - extra expenses, loss of income
Wealth Losses
- Judgment from lawsuit
- Legal Fees
Factors Affecting Risk
- Peril
- Frequency
- Severity
- Hazard
Peril
Immediate cause of the loss
-fire, flood, theft, etc
Frequency
How often do the losses occur
Severity
- How bad
- severity is conditional upon frequency
Hazard
- Underlying condition behind frequency
- increases frequency
- increases severity and frequency
Physical Hazard
- Location
- Construction-
- Use
Location
- If peril is flood then living at shore is physical hazard (frequency)
- If peril is fire, then distance to fire hydrant is physical hazard
Construction
-Fire peril; wood structure is physical hazard (frequency and security)
Use
- University Class vs. Church
- fire is peril, use of building as church poses more physical danger than university class
Moral Hazard
- Act differently because of the existence of insurance
- frequency or severity increases
- car stolen to collect insurance money, arson on house to collect insurance
Moral Hazard Common Thread
- Presence of Insurance
- Change of Behavior
Moral Hazard in Health Insurance
- Cash Bar vs. Open Bar
- Those with healthcare consume more than those without it
- Price is fixed for those with insurance
- Lowers user cost
- Lower cost equals higher demand
- Not bad behavior but costs more in the end
Morale Hazard
- Carelessness concerning losses
- Has nothing to do with existence of insurance
Financial Consequences of Risk
- What does risk cost an organization
- How does risk impact an organization
- How can that impact society?
Expected Cost of Loss
- Financial losses-lawsuit and legal fees
- Goodwill and loss - loss of reputation
Cost to Manage Risk
- Safety Programs
- Training
- Buy Insurance
Residual Uncertainty
- Loss of goods or services because they are deemed too risk- society loses something valuable
Risk Making Process
- Manage Pure Risk (TRM) and speculative risk (ERM)
- Goal is to minimize the financial impact on an organization
Function in Firm
- Continuously Evolving
- Does not equal insurance buying
Evolution
- 1950s, did not manage risk, just bought insurance
- Mid 1960s Snider (Temple) coins term (RM)
- Becomes strategy
- 1950s very narrow and non-strategic
- Present - very important function in a firm, very broad
Steps in RM Process
- Identify Exposure to Loss
- Evaluate Exposure to Loss (4)
- Identify possible alternatives (5+6)
- Select among the alternatives (7)
- Implementation of the chosen options (9)
- Reevaluation periodically the chosen strategy
Loss Exposure
- Possibility of a financial loss that a particular entity faces as the result of a peril striking a thing of value : Stuff Happens
- Most crucial step
How to Identify Loss Exposures
- Inspections
- Contract Analysis
- Hold Harmless Agreements
- Look at Past Information: does not work in all situations, Dynamic Risk
- Share information with other similar firms
- Checklist/Standardized Surveys from insurance companies
- Flow Chart Approach
- Ask employees/managers in the firm
- Financial Statement Approach: Balance Sheets, Assets (Physical, Non-Physical)
- Liabilities - income statement, who owes money, sources of revenue
- Budget
Types or Categories of Loss Exposure
- Property
- Net Income
- Personnel
- Liability (Topic 3)
Property Loss Exposure
- Real Property (land, building)
- Personal Property: tangible (equipment), intangible (goodwill, patent)
- Legal Interest in Property:
1. Financial (stake in property)
2. Ownership: most common, present or future - Buyers and Sellers
- Shipping Products
- FOB (Freight on Board Point), Ebay example
- Balie Interest
- Tenant Interest
Bailee Interest
- Entity that receives property from another under a contract of bailment
- Interest for bailee is legal liability to return or cost to replace the property
Tenant Interest
- Continued Use
- Responsibility for returning property in reasonable condition
Net Income Loss Expenditures
- Business Interruption
- A firm suffers a primary loss - as the result suffers a secondary loss that results in indirect expenses
- Normal production process is interrupted
Events That Cause Net Income Loss
- Damage to property owned by firm
- Delivery truck is stolen: extra costs - retail and orders not filled
- Damage to property owned by others: key supplier has a property loss
Personnel Loss Expenditures
- key employee suffers personal loss
- loss of income
- medical expenses
- personal issue
- firms may also suffer: decrease in revenue: sales down, decisions not made
- increase in expenses - cost of replacing the person
Liability loss Exposure Plus ERM
- Bad behavior
- Breaking a contract
- Behavior classified as either intentional or unintentional
Negligence and Liability
-L.L. established when: negligence, loss or damage
What Constitutes Negligence
- Failure of a person to exercise the proper degree of care
- Burden of proof is on the injured party
- Absolute Strict Liability
- L.L. established because accidents happen
- Imposed whether anyone was at fault: children, workers comp
Measurement Issue
- Usually easy to establish injury or damage occurred
- Establishing amount is usually difficult
Measurement of Loss
- Property losses (PD)
- Bodily Inury (BI): special damages
1. compensate of measurable losses
2. easy to calculate
Measuring Bodily Injury Damages
- General Damages:
1. Compensate for intangible losses
2. Pain and Suffering
3. Mental Anguish
4. Difficult to estimate and measure - why?
Punitive Damages
- Amounts assessed as a form of punishment
- Gross Negligence is involved
- Difficult to estimate and measure - why?
Defenses of Liability
- Assumption of risk by the injured party
- One recognized the dangers involved in an activity
- Voluntarily chooses to encounter it: attending a hockey game
- Comparative/Contributory Negligence: plaintiff was partially to blame for what happened
Res Ipsa Loquitoc
- The thing speaks for itself
- Modification to law of negligence
- Presumption of negligence on part of defendant
- Fact of injury is sometimes enough
- Requirements:
1. Would not occur without negligence
2. Defendant exclusively controls tool/equipment
3. Injured party does not contributor to loss: dentists remove wrong teeth
Vicarious Liability
- Negligence of two or more parties, contributes to the injury or damage
- Injured party may recover the entire amount of compensation from any negligent party who is able to pay, regardless of the degree of that party’s negligence
- Search for deep pockets
Product Liability
- Manufacturers of a faulty product that inures someone or damages property, may be held L.L.
- Negligence - negligently designed, proper warning not given to consumer
Product Liability Losses
- Cost of defending and paying claims for injury
- Cost of recalling any batches of products suspected of being defective
- Damage to your name
Premises Liability
- Owner or tenant may be held liable for damages if someone is injured
- If property of others is damaged as a result of a condition in or arising out of the premises
3 Categories: Trespasser, Licensee, Social Guest/Invitee
Trespasser
Someone who comes without right or consent, only obligated to abstain from doing intention harm
Licensee
Comes onto property with knowledge of owner, no purpose or benefit to owner, must warn of hidden dangers
Social Guest/Invitee
Been invited for some purpose, customer in store, must keep premises safe so no harm comes
Animal Liability
Exotic Animals - Strict Liability
Dogs:
- Some states have strict liability
- Some states- if dog never bit before could escape liability
Enterprise Risk Management
- Manage and Sieze Opportunity
- Risk based approach to managing an enterprise
- Very Strategic
- Scientific Approach
Hazard Risk
- Fire
- Floods
- Lawsuits, Liabilities
Financial Risk
- Prices
- Volatility
- Liquidity
- Credit
- Interest Rates Risk
Operational Risks
- Arise out of business operations
- Manufacturing Products: supply chain service provider failures, system failure, product recall
- Regulatory Issues
- Employment Practices/Company Policies and Procedures: discrimination, turnover, workplace violence
Strategic Or Business Risk (SWOT)
- Customer Service Issues
- Public Relations
- Competition
- Ethical Issues
- Social Trends
TRM Vs ERM
- TRM is silo or departmentalized approach
- TRM focuses mainly on hazard type risks (flood, fire, etc)
- Financial type risks handled by CFO, Finance or accounting
- Other Risks Maybe Handled by their specific areas
- Not much effort to make relative comparisons among various risks to understand the cumulative impact on a firm
ERM
- ERM is an integrated approach
- occurs at enterprise level instead of individual departments
- RM activities heavily impact business decision
- Designed to facilitate comparison and evaluation
- Identify risks and determine if risks are correlated or independent
- CRO in charge - can override department functional areas-
Measurement/Evaluation of Exposure to Loss
- Step 2 in RM process
- Risk: Uncertainty, variation around expected losses vs. actual
Expected Loss = P*
- Core of RM decision making
- P* and the variation around it; planned losses, expected severity, E(X)
- Basis for insurance pricing
Gross Premium
- Premium charged for insurance exposure unit
- Must cover all costs of insurers
- Insurer does not know all of the costs until the last claim is settled
- Losses, expenses, administration
- Gross Premium = Pure Premium + Loading Risk Charge
Pure Premium: P*
- Amount of gross premium sufficient to pay for losses only (P*)
- It must be an estimate; can be wrong
- Actual losses may not be equal to expected losses; Break Even, Profit, Loss
- Insurers face an additional risk - estimation risk
Risk Charge
- Reflects the estimation of risk for an insurer
- Needed because P* is an estimate
- Cushion
Influences Size of Risk
- Accuracy of estimation of P*
- If confident of P*, small risk charge: Life, Auto, Homeowners- small charge
- If not confident of P*, risk charge is very high: Terrorism Risk, Internet Risk
- Big events such as Superbowl or Olympics
Intermediate Risk Charge
- Natural disasters - floods
- Some liability risks
Loading
- General Office expenses/Fixed Costs
- State Premium taxes
- Advertising/Commissions
- 20% -30% of premium
Exposure Unit
- things expected to loss
- cars, drivers, building, person’s life
- P* o single Unit
- P* on a group of similar units
Probability
- Measures the likelihood of an event
- Ranges from 0 - 1
- If P = 1, certain
- If P = 0, Impossible
Mutually Exclusive
- Cannot occur at the same time
- Individual probabilities must equal 1
Random Variable
- Outcome depends on some chance event
- The results are random
- Rolling dice; Coin Flip
Random Variables in RM
- Frequency
- Severity
- Total $ losses in a given time period: depend on frequency and severity
Frequency
Total # of losses in a given time period
Severity
Dollar value of losses that do occur (severity)
Probability Distribution
- Graph or table which indicates for each outcome of a random event, the probability of that occurring
- Uniform distribution
- Bell Curve
Measure of Central Tendency
- Mean = Average = Expected Value = P*
- Median = Midpoint
- Mode = Outcome that occurs most frequently
Measure of Dispersion
- Variance, Standard Deviation, and Coefficient of Variation
- Greater Dispersion (Variance, S.D., Coeff) = greater risk
Law of Large Numbers
- Over time the more data you collect ore more observations that occur the more accurate the estimate
Trying to Estimate P* - Expected Loss
- First determine frequency of loss: calculate # of losses
- Second determine severity of loss: calculate loss amounts
- Measure total loss exposure: ultimate question, how much will it cost?
Frequency
- To figure of frequency = F
- Can use two different measures
1. Total # of accidents/Total # of Drivers
2.
Severity
- First assume severity not random
- when losses
Priori Probability
- Can be deduced in advance: coin flip, dice
- Assumption: All possible outcomes are known, all outcomes equally likely, all outcomes mutually exclusive
Statistical Probability
- Make estimates based on statistics
- Run an experiment and use results from collected data
Maximum Probable Loss
- Largest loss most likely to occur
- Not always an exact answer - key is how you present it
Risk Management Alternates
- Evaluate Alternatives to managing the risks you or your firm faces
- Step 3 in RM process
Risk Control Options
- Activities or attempts to control the risks
- Reduce frequency of the loss
- Reduce the severity of the loss
- Improve predictability of loss
- Less Variable: objective risk falls as result, decrease in coefficient in variation
Avoidance
- Stop engaging in activity that causes loss
- Or never engage in activity that causes loss
- Risk reduced to zero if properly implemented
Problems With Avoidance
- Some can’t be avoided
- May not be feasible or desirable
- Opportunity Cost - lose profits associated with activity
- Legacy Cost; may avoid future losses by avoidance, might not avoid costs from past
- Trade one risk for another
When Is Avoidance a Good Strategy
- Usually high frequency, high severity claims
- Conduct cost benefit analysis
- When costs of risk is greater than benefit (profit)
- Avoidance is mutually exclusive with respect to all other options
Loss Prevention
- Attempts to reduce the frequency or probability of the loss
- Does not completely eliminate it
- Activities that attempt to intercept or break the chain of events that lead to loss
- Take place prior to loss
- Training program, safety inspections, quality control
Loss Reduction
- Assume Loss will occur
- What can be done prior to or after
- Reduce severity
- Pre loss, loss reduction activities: exit signs, sprinkler system, fire drill
- Post Loss - loss reduction activities: salvage operations, legal defenses, crisis management, rehabilitation of injured worker
Separation of Exposure Units
- Break Items or activities or assets of responsibilities down into smaller parts and separate them
- One delivery truck vs. 2
- Limits size of loss from any one occurrence
- Works well to reduce net income loss exposures
- Impact of lowering the coefficient of variation
- Cost may be in terms of the cost of multiple exposure units and the losses to these multiple units
Duplication of Exposure Units
- Key asset or activity is replicated and held in reserve
- Spare parts, back up disks, copies of record
- Critical that replicates kept in reserve
- Do not use
Risk Transfer Control Type
- Shift the activity or asset exposed to loss to a third party
- Also shifts the loss; sale of a building, sell a dangerous product line
- Loss exposure cannot come back to you
Risk Financing Options
- Deals with sources of funds to pay for these losses
- External or Internal Funds
Risk Transfers of the Financing Type
- See external sources from 3rd parties to finance losses
- Still have asset or activity exposed to loss
- Transfer the financial responsibility for the loss, not the asset or activity itself
- Insurance
Insurance
- Transfer the financial responsibility of the loss to the insurer
- But not the asset or activity itself
Non-Insurance Risk Transfers
- Leases
- Hold Harmless Agreement
- Retention
Leases
- Tenant is responsible for all property losses while occupying the property
- If tenant fails, then the owner is ultimately responsible
Hold Harmless Agreement
- Someone contractually accepts risk for you
- Contractor doing job, vendor performing a task, company promises a firm doing work for them that they accept all responsibilities
Retentino
- A firm or individual engaging in retention assumes the financial responsibility for losses that do occur
- Retain the exposure to loss; not buying insurance, insurance with deductible
Funded Retention
- A firm sets aside funds every period to pay for losses
- Better for losses that are predictable and high in severity
Unfunded
- No separate fund to pay for losses
- Pay for losses as they occur from money you borrow
- Better for losses that are low frequency and low in severity
Active Retention
- Deliberate decision to practice retention
Passive Retention
- Retaining the exposure to loss, but you may be unaware
- Usually results from failure to identify
Self Insurance
- Planned and Funded Retention
- Usually for significant loss exposures where many exposure units exist
- Formal Program, not just something that happens, well thought out strategy
- Fairly Predictable: Medical Plan for Employees
- Long pay out period: worker’s compensation
Self Insurance Advantages
- Flexibility - most contracts are very standardized, avoid state mandated benefit laws
- No Loading - No premium taxes, no administrative expenses, no marketing expenses, Premium = P* risk charge + loading
- Money - any credits are invested internally - which would probably produce higher rate; saving from any loss prevention/reduction goes directly into your pocket instead of insurance company
Self Insurance Disadvantages
- Catastrophic Loss Possibility
- Firm may have to perform administration functions
- Can be PR nightmare
- Hard to return to insurance market once you have left
- Income Tax Treatment
Self Insurance Disadvantages/ Catastrophic Loss Possibility
- One large loss could wipe you out
- can handle with stop loss insurance - but you must pay premium
- insurance contract with very large deductible - stop loss
- Aggregate is a total amount limits
Self Insurance Disadvantages/Firm may have to perform administration functions
- Claims settlement, return to work programs, wellness programs, etc
- Only solve with ASO (Administrative Services Only) contract with insurer
- Can hire a TPA (Third Party Administrator) to handle those finances
- Again, ASO + TPO services cost money
Self Insurance Disadvantages/Can Be PR Nightmare
- Could give the impression that the company is financially unstable
- Can’t pass the blame to the insurer when denying claims
- Hard to return to insurance market once you have left (High Risk)
Self Insurance Disadvantages/Income Tax Treatment
- Insurance; premiums are tax deductible in tax year when they are paid
- Cost of doing business = premium
- Premium represents cost of losses that have yet to occur
- Allows firm to pre-deduct cost of future losses
Captives + Risk Retention Groups
- Hard Market’s occur (Post 9/11-terrorism) where cost of insurance rises tremendously
- Certain coverage have increasing costs (Current medical mal practice)
- Captives and RRG formed to handle
- Captives and RRG also help the income tax issue with self funding
Captive Insurer
- Insurance Company is wholly owned subsidiary of company (parent is not in the insurance business)
- Primary purpose is to insure the risks of the parent or parents (If more than one company)
- Could be similar companies, an association of municipalities, possibilities are limitless
Two Types of Captive Insurer
- Single Parent
- Association Captive with more than one parent
Captive Insurer Advantages
- Helps during hard markets
- Often located in Bermuda or Cayman Islands giving regulatory and income tax advantages
- Tax treatment in US; can write of premium if it is a true risk transfer,
- True Risk Transfer = parent risk makes up no more than 30% of the risk portfolios
