1 Introduction to Risk and Insurance

2 Basic Terminology Risk Risk - not just uncertainty of financial loss; - possibility of deviation between actual and expected outcomes - measured in units called “exposures”

3 Insurance - not just transfer of risk; - device for transferring, sharing, and reducing risk by combining a sufficient number of exposure units to make individual losses collectively predictable

4 Law of Large Numbers Statistical basis for insurance Statistical basis for insurance Crucial to the success of the product Crucial to the success of the product Most unique characteristic of insurance Most unique characteristic of insurance Makes Insurance a financial product different from any other Makes Insurance a financial product different from any other

5 How Insurance reduces risk Assume chance of a house loss is 1/100 Assume chance of a house loss is 1/100 If you have only one house, will yours be that one? If you have only one house, will yours be that one? What if you have 10 house, will you have one burn? What if you have 10 house, will you have one burn? What if you have 100 houses, will you likely have one burn? What if you have 100 houses, will you likely have one burn?

6 How risk is reduced Need to examine Need to examine The number of # exposures(#) The number of # exposures(#) Expected Losses (EL) Expected Losses (EL) Actual losses (AL) Actual losses (AL) Difference between actual and expected (Risk) Difference between actual and expected (Risk)

7 How risk is reduced (cont.) #ELALRisk 1?? % % 10, % 100, %

8 Risk Management the process of identifying and analyzing all possible loss exposures, selecting a method of handling the exposure, and monitoring the method and exposure regularly the process of identifying and analyzing all possible loss exposures, selecting a method of handling the exposure, and monitoring the method and exposure regularly Who is a risk manager? Who is a risk manager? Who has practiced risk management personally? Who has practiced risk management personally?

9 Basic Risk Management techniques: Basic Risk Management techniques: risk avoidance risk avoidance risk control (hazard or loss reduction) risk control (hazard or loss reduction) risk retention risk retention risk transfer risk transfer

10 Areas of Exposures Traditional Areas Property Losses Property Losses Liability Losses Liability Losses Net Income Losses Net Income Losses Personnel Losses Personnel Losses Recently Added Areas Corporate Governance Corporate Governance Management Liability Exposures Management Liability Exposures

11 Common Terminology Loss, Peril, Hazard Loss, Peril, Hazard Physical, morale, and moral Physical, morale, and moral Law of Large Numbers Law of Large Numbers Liability/Casualty Liability/Casualty Third Party Contracts Third Party Contracts Named perils vs open perils Named perils vs open perils Deductible Deductible to prevent over utilization of coverages to prevent over utilization of coverages to prevent filing small claims to prevent filing small claims

12 Negligence Negligence Proximate Cause Proximate Cause Reasonable Person Rule Reasonable Person Rule Accident vs occurrence Accident vs occurrence Bodily Injury Bodily Injury Property Damage Property Damage Personal Injury Personal Injury Not physical injury Not physical injury damage to reputation or mental state damage to reputation or mental state Advertising Injury Advertising Injury Same as PI but to a business Same as PI but to a business

13 Conditional Conditional Utmost Good Faith Utmost Good Faith Unilateral Unilateral Adhesion Adhesion Personal Personal Aleatory Aleatory Indemnity Indemnity

14Indemnity Insurable Interest Insurable Interest Subrogation Subrogation ACV Loss Measurement (versus valued/face amount contracts) ACV Loss Measurement (versus valued/face amount contracts) Other Insurance Clause Other Insurance Clause Pro Rata Clause Pro Rata Clause Other Restrictive Clauses Other Restrictive Clauses Policies enforcing indemnity: property, business income and extra expense, and liability Policies enforcing indemnity: property, business income and extra expense, and liability Policies not contracts of indemnity: life insurance Policies not contracts of indemnity: life insurance

15 Insurable Interest Life Insurance: Life Insurance: Self Self Spouse Spouse Dependency Dependency Key Person Key Person Property Insurance Property Insurance Ownership Ownership Creditor Creditor some leasing situations some leasing situations legal liability legal liability

16 How losses may be measured: Face Amount Face Amount Actual Cash Value Actual Cash Value Replacement Cost Replacement Cost Functional Replacement Cost (Repair Cost for functionally equivalent materials if impossible to duplicate Functional Replacement Cost (Repair Cost for functionally equivalent materials if impossible to duplicate Stated Value Stated Value after loss, insurer may challenge and pay less after loss, insurer may challenge and pay less Agreed Value Agreed Value scheduled value scheduled value Fair Market Value Fair Market Value

17 Reasons for Exclusions: Reasons for Exclusions: May result in catastrophic loss May result in catastrophic loss Should be covered elsewhere Should be covered elsewhere Not fortuitous (unexpected and unforeseen) Not fortuitous (unexpected and unforeseen) To control moral or morale hazards To control moral or morale hazards To eliminate duplicate coverage To eliminate duplicate coverage To eliminate coverage not needed by the average insured To eliminate coverage not needed by the average insured

18 Underwriting Concepts Underwriter - one who selects and categorizes risks Underwriter - one who selects and categorizes risks Requisites of an insurable risk: Requisites of an insurable risk: the Law of Large numbers must apply the Law of Large numbers must apply the loss may not be intentional the loss may not be intentional the loss may not be susceptible to catastrophe the loss may not be susceptible to catastrophe the loss must be economically significant to the applicant the loss must be economically significant to the applicant the loss must be measurable the loss must be measurable Adverse Selection Adverse Selection

19 Coinsurance In Health Insurance In Health Insurance Purpose is to prevent unnecessary use of coverage Purpose is to prevent unnecessary use of coverage 100% paid if loss is “severe” 100% paid if loss is “severe” In Property Insurance In Property Insurance Purpose is to promote rate equity Purpose is to promote rate equity Alternative system would be scaled rating system Alternative system would be scaled rating system Have / Should x Loss = $ amount paid Have / Should x Loss = $ amount paid

20 Common Policy Clauses Concealment and Fraud Concealment and Fraud Liberalization Clause Liberalization Clause Proof of Loss Proof of Loss Appraisal Clause Appraisal Clause Abandonment Abandonment Cancellation Provisions Cancellation Provisions Mortgagee Clause Mortgagee Clause Duties After a Loss Duties After a Loss Assignment Assignment No Benefit to Bailee No Benefit to Bailee