T1 MHA, C1 MAMDOUH HAMZA AHMED Professor of Risk Management & Insurance Fellow of the American Risk & Insurance Management Society (FRIMS) Faculty of Commerce Cairo University 2006  CH1: RISK IN OUR SOCIETY

T2 MHA, C1  CONTENTS 1-Risk in our Society. 2-Insurance & Risk. 3-Risk Management. 4-Financial Services Companies. 5-Legal Principles in Risk & Insurance. 6-Analysis of Insurance Contract. 7-Life Insurance Contractual Provisions. 8-Life Insurance Policies.  CH1: RISK IN OUR SOCIETY

T3 MHA, C1  CONTENTS (Cont’) 9-Annuities. 10-The Mortality Table. 11-Pricing Life & Health Insurance. 12-Life Annuities Premiums. 13-Life Insurance Premiums. 14-Gross Premium.  CH1: RISK IN OUR SOCIETY

T4 MHA, C1  Definition of risk: “uncertainty concerning the occurrence of a loss”.  Objective Risk: “the relative variation of actual loss from expected loss”. -Objective risk declines as the number of exposures increases. -Objective risk varies inversely with the square root of the number of cases under observation. -Objective risk can be statistically measured by the coefficient of variation.  CH1: RISK IN OUR SOCIETY

T5 MHA, C1 The Law of large numbers states that: "as the number of exposures units increases, the more closely the actual loss experience will approach the expected loss experience". Subjective Risk: “uncertainly based on a person’s mental condition or state of mind”. -Subjective risk varies depending on the individual. -Two persons in the same situation can have a different perception of risk, and their behavior may be altered accordingly.  CH1: RISK IN OUR SOCIETY

T6 MHA, C1 -High subjective risk often results in conservative and prudent behavior, while low subjective risk may result in less conservative behavior.  Chance of loss: “the probability that an event will occur”. 1-Objective Probability: is “the long-run relative frequency of an event based on the assumptions of an infinite number of observation and of no change in the underlying conditions”.  CH1: RISK IN OUR SOCIETY

T7 MHA, C1  First, can be determined by deductive reasoning (ex: probability of getting a head from the toss is ½ because there are 2 sides).  Second, can be determined by inductive reasoning (ex: probability that a person age 21 will die before age 26 by analysis of past mortality experience). 2-Subjective Probability: is “the individual’s personal estimate of the chance of loss”.  CH1: RISK IN OUR SOCIETY

T8 MHA, C1 -Subjective probability doesn't coincide with objective probability (ex: buying a lottery ticket on your birthday, you overestimate chance of winning). -Many factors influence subjective probability: age, gender, intelligence education, etc…).  CH1: RISK IN OUR SOCIETY

T9 MHA, C1  Chance of Loss Distinguished from Objecive Risk: Chance of loss is the probability that an event that causes a loss will occur but, objective risk is the relative variation of actual loss from expected loss. -Chance of loss may be identical for 2 different groups, but objective risk may be different. Ex: 10,000 homes insured in Cairo & 10,000 homes insured in Alex. & chance of loss in each city is 1%.  CH1: RISK IN OUR SOCIETY

T10 MHA, C1 Thus, on average, 100 homes should burn annually in each city. If the annual variation in losses ranges from 75 to 125 in Cairo, & from 90 to 110 in Alex. Then objective risk is greater in Cairo even though the chance of loss in both cities is the same.  Peril: is “the cause of loss”. If a car is damaged in a collision, collision is the peril (cause) of loss.  CH1: RISK IN OUR SOCIETY

T11 MHA, C1  Hazard: “a condition that increases the chance of loss”. There are 3 types of hazards: 1-Physical Hazard: is “a physical condition that increases the chance of loss”. Ex: icy roads increase chance of auto accident & a defective lock increases chance of theft. 2-Moral Hazard: “dishonesty or character defects in an individual that increases the frequency or severity of loss”.  CH1: RISK IN OUR SOCIETY

T12 MHA, C1 Ex: faking an accident to collect from the insurer, inflating the amount of a claim, & intentionally burning an insured property. -Moral hazard is present in all forms of insurance, & it is difficult to prevent. -Dishonest insurds rationalize their actions on “the insurer has plenty of money”. This is wrong, insurers transfer this cost to the insurds again (increases the premiums).  CH1: RISK IN OUR SOCIETY

T13 MHA, C1 Methods of controlling moral hazard: underwriting, deductibles, waiting periods, exclusions. 3-Morale Hazard: “carelessness or indifference to a loss because of the existence of ins.”. Ex: leaving car keys in unlocked car increases chance of theft & changing lanes without signaling increases chance of accident.  CH1: RISK IN OUR SOCIETY

T14 MHA, C1  Pure & Speculative Risks: 1-Pure risk: “a situation in which there are only the possibilities of loss or no loss”. Ex: premature death, car accident, …,fire. 2-Speculative risk: “a situation in which either profit or loss is possible”. Ex: purchasing shares, going into business. Why Distinguishing between pure & speculative: First: private insurers insure only pure risks. Second: the law of large #'s applies easily to pure risks than to speculative risks  CH1: RISK IN OUR SOCIETY

T15 MHA, C1 Third: society may benefit from occurring speculative risks but, harmed from pure risks. Ex: a firm may produce cheap computers. So, some competitors went into bankruptcy. But, society benefits from cheap products.  Fundamental & Particular Risks: 1-Fundamental Risk: “a risk that affects the entire economy or large #'s of persons”. Ex: unemployment, war, earthquakes & floods result in billions of dollars of property loss & large #'s of deaths.  CH1: RISK IN OUR SOCIETY

T16 MHA, C1 2-Particular Risk: “a risk that affects only individuals & not the entire community. -Ex: car theft, bank robbery & house fire.  Distinguishing between Fundamental & Particular Risk: most fundamental risks need governmental assistance ins. & subsidies to be covered.  Types of Pure Risk: personal, property & liability risks. 1-Personal Risks: “risks that directly affect an individual". -Ex: loss or reduction of earned income, extra expenses,... etc.  CH1: RISK IN OUR SOCIETY

T17 MHA, C1  There are 4 personal risks: 1\1-Premature Death: is “the death of a household head with unfulfilled financial obligations”. -Ex: dependents to support, a mortgage to be paid off, or children to educate. -Thus, the death of a 10 yrs old child is not a “premature death” in the economic sense (no financial obligations).  CH1: RISK IN OUR SOCIETY

T18 MHA, C1 2\1-Insufficient Income During Retirement: -Retirement means losing earned income. -Unless having sufficient private financial assets or social security or private pension, you will be exposed to financial insecurity. -Also, workers do not have enough saving for a comfortable retirement. 3\1-Poor Health: long-term sick or disability cause: loss of income & benefits, cost of medical bills & to take care of the disabled person.  CH1: RISK IN OUR SOCIETY

T19 MHA, C1 4\1-Unemployment: it causes financial insecurity in at least 3 ways: First: losing salary & employee benefits. Second: working part-time means reduced income & not covering their needs. Third: long period of unemployment means savings (if available) may be exhausted. 2-Property Risks: property are exposed to be lost or destroyed by fire, flood, accident,…etc.  CH1: RISK IN OUR SOCIETY

T20 MHA, C1  Types of property losses: 1\2-Direct Loss: “a financial loss that results from the physical damage, destruction, or theft of the property”. Ex: if a restaurant is damaged by a fire, the physical damage (cost of replacement or repair) is a direct loss. 2\2-Indirect or consequential loss: “a financial loss that results indirectly from the occurrence of a direct loss”. Ex: loss of profits, loss of rents, loss of use of the building, loss of market, & extra expenses while the restaurant is being repaired.  CH1: RISK IN OUR SOCIETY

T21 MHA, C1 3-Liability Risks: You can be held legally liable if you do something that result in bodily injury or property damage to someone else. -Motorists can be held legally liable for the negligent operation of their vehicles.  CH1: RISK IN OUR SOCIETY

T22 MHA, C1 Liability risks are important than others: First, no upper limit of the amount of loss. Second, a lien can be placed on your income & financial assets to satisfy a legal judgment. Third, legal defense costs could be enormous.  CH1: RISK IN OUR SOCIETY

T23 MHA, C1  Methods of Handling Risk: 2 categories: A-Risk Control: refers to techniques that reduce the frequency & severity of losses & includes: 1-Avoidance.2-Loss Prevention. 3-Loss Reduction. B-Risk Financing:refers to techniques that provide for the funding of losses & includes: 1-Retention.2-Noninsurance Transfer. 3-Insurance.  CH1: RISK IN OUR SOCIETY

T24 MHA, C1 A-Risk Control: 1-Avoidance: you can avoid the risk of losing your car in an accident by not having one, divorce by not marrying & death in a plane crash by not flying. -But, it is neither practical nor desirable choice because you can't avoid all risks & you avoid some risks & creates new. 2-Loss prevention: aims at reducing prob. of loss (frequency). Ex: traffic lights & increasing fines for high speed reduce # of loss.  CH1: RISK IN OUR SOCIETY

T25 MHA, C1 3-Loss reduction: aims at reducing severity of loss after it occurs. -Ex: installing a sprinkler, fire walls & seats belts reduce amount of loss. B-Risk Financing: 1-Retention: an individual or a business firm retains all or part of a given risk. -Risk retention can be either active or passive. 2-Non-insurance Transfers: risk is transferred to a party other than an ins. Co such as. 1/2-Transfer of risk by contracts: risk of a rent increase can be transferred to the landlord by a long-term lease.  CH1: RISK IN OUR SOCIETY

T26 MHA, C1 2/2-Hedging price risks: risk of price change can be transferred to a speculator by purchasing & selling futures contracts 3/2-Incorporation of a business firm: risk of the firm having insufficient assets to pay business debts is shifted to the creditors. 3-Insurance: risk is transferred to an insurance company that spread the loss over huge # of units.  CH1: RISK IN OUR SOCIETY