Lesson 18 FIN 403 Announcements 1. FIN 403 Mark Book explained (on screen) 2. Participation and Bonus explained (on screen) 3. All assignments must be submitted during class. Assignments will no longer be accepted via email. Note: All rough work must be submitted (with the name of the contributor) attached to the typed written assignments. 4. These students must see me. 5. Exam take up (partial) 6. Lesson. FIN 403 Mark Book Step 2 Evaluating the Risk Step 1 listed the important risks. Step 2 will evaluate using TWO CRITERIA. a) The size of the potential loss. b) The frequency or probability of occurrence. Question: Which risks can you accept? Which risks can you not accept? Answer: These are personal decisions. Insupportable Risks A risk is not worth taking (is insupportable) if it materially (financially) affects a family’s standard of living. If the loss causes us to suffer, at the expense of losing an acceptable standard of living, we must insure the risk. Question. Can you give an obvious example of an unsupportable risk? Answer. See the screen. Life. Property. Describe the Process. Large versus small losses Question. Is the theft of a 100,000 RMB car a big loss or a small loss? (supportable or insupportable). Some people can afford to replace that, while other can not. The factors involved in making the decision include, a) is my insurance rate (premium) very high so I will only insure for damage caused to others and not the replacement of my car? What would you do? b) Is my car worth so little that nobody is likely to want to steal it and if it gets destroyed in an accident, the cost of the premium over 10 years is more than I would pay to replace it? What would you do? What is the probability of the risk occurring? How likely is, a) Your home to be destroyed by an earthquake, a tornado or hurricane b) Your home to be damaged by a wind storm c) Your car to be seriously damaged in an accident d) Your home to robbed and you lose your television, computer and jewelry e) A fire to destroy your garage f) You to be seriously injured and be unable to earn a living g) You to die How much will these things cost to replace (home, toys, life)? (This is where you use your notebook and write down the examples of replacement costs versus the cost to insure the items) Home: $150,000 Garage: $50,000 Car: $15,000 Television: $800 Computer: $1,000 Jewelry: ??? Life: Lost earning that would support family Disability: Lost earning… Step 3 Controlling the Risk Question: How can you control Risk? Avoidance: you can avoid injuring yourself in a dangerous sport by not playing that sport. Example: Sky diving, hockey, karate, boxing, deep sea scuba diving, alligator wrestling, race car driving. Separation: Parents who travel on different airplanes will not be killed in the same accident, leaving the children without financial support. Parents who work for the same company risk losing their jobs and income stream if the company goes bankrupt. Prevention or Reduction of Frequency Prevention or Reduction of Frequency is the most useful way to minimize risk. Examples include: a) Eat healthy food and exercise frequently b) Protect property with smoke detectors, cameras to deter thieves, bolt locks on doors, locks on windows, preventative maintenance on all property (indoor and outdoor) c) Drive your car carefully d) Incorporate your family business Refer back to Tenant Incident Reports. Step 4 Financing the Risks Question. What is meant by the statement, “Insurance is based on the law of large numbers”. If the occurrences of some event are independent of each other, in a large population, the probability of their occurring can be represented by the average observed frequency. Question. Name an example. Answer. Slipping on these stairs. Car accident. One occurrence does not cause another. Financing the Risks Question. Why is it so important to keep track of accident occurrences? Example: Tenant Incident Reports. Answer. If the premiums collected add up to more than the predicted cost to replace or repair the particular damage, the population can share the risk (of an insupportable loss). If the cost to replace or repair is more than people are able to pay in insurance premiums, the risk is not insurable. Financing the Risks Question. What is an example of a risk that private insurance companies are not willing to take but governments are willing to take? Answer. Government funded Employment Insurance. Society shares the risk by allowing the government to tax us and make payments to people who lost their jobs, if the loss was not their fault. Employment Insurance is a form of WELFARE. Employment Insurance in Canada has payment limitations which are approximately 50% of a $40,000 salary. Financing the Risks Question. What kinds of risks that are so expensive to insure, that private insurance companies will not offer insurance coverage? Answer: Damage caused by war (foreign invasion) Nuclear attack Terrorism In some geographical locations, earthquakes Health – if there is a pre-existing condition. Other things to know about… Moral Hazards are not insurable. They occur when the loss is due to deliberate (intentional actions or choices) of the insured. Self Insurance is not insurance but is a decision to not finance a risk. A family may not insure a risk because the loss may not negatively affect their standard of living OR, they may not have enough money to pay for the insurance and must take the chance that they will not suffer the loss. Example. A retired person does not have enough money to insure their home. If they spent their money on insurance, they would only have enough money for 10 months of food. If they own their home, they can make the choice to not insure. Example Pooling Funds to insure an insupportable risk. A town has 1000 homes and each home owner pays $500 for one year of home insurance (fire, liability and theft). 1000 * $500 = $500,000 The observed frequency of fires, liability costs and thefts comes to $350,000 in payouts annually for the insurance company. The cost to run their business is $50,000. The owners of the insurance company will earn a profit and the insured people will be protected if the frequency of occurrences does not increase to the point that the amount collected (including company profit) is less than the amount collected in premiums. In Class Exercise: Do the math on a piece of paper in front of you now and when you are done, hold it up for me to see. Do it now. When does pooling for insurance not work? Insurance does not work when the incidents are related to each other. If the incidents are related in some way, then the probability is not stable, since the existence of some occurrences increase the probability of more of them. Question: What are the reasons that insurance companies do not insure against job loss? In class exercise: Maximum group size is 4 people Read paragraphs 3 and 4 on page 193 starting with “This pooling or insurance only works under some conditions…. Answer the question (above ~ in red) and give your own examples. NOTE: A summary of the paragraph will not earn bonus or participation marks. You must think and give real life examples. Hand in your work before you leave class today. Those that need to additional work to earn bonus marks will be returned in one or two classes. Old Age Pension is a form of Insurance and Welfare The money for old age pensions must come from the citizens who pay for it. The government budgets for it and must know how much will need to be available in future years. They must begin making the investments to pay for those expenses long before they are paid out to retired persons. A life table is a concise way of showing the probabilities of a member of a particular population living to or dying at a particular age. Life tables are used to examine the mortality (DEATH) changes in the population over time. Actuarial Tables Actuarial Tables show the probability that an event will occur, under every possible combination of age, sex, occupation, etc. Mortality Tables show the probability of death for many different lifestyles and occupations, sex, etc. Examples: men vs. women, smokers vs. non-smokers, factory workers vs. office workers vs. coal mine workers vs. every other type of employment ALSO people of different nationalities, colours, ethnic backgrounds… Actuarial Society of Hong Kong Careers in Risk Management Actuaries put a price tag on future risks. Actuaries have been called financial engineers and social mathematicians because their unique combination of analytical and business skills helps to solve a growing variety of financial and social problems. Actuaries make financial sense of the future. An actuary applies mathematical models to problems of insurance and finance. Actuaries improve financial decision making by developing models to evaluate the current financial implications of uncertain future events. Step 5 Monitoring the Risk The risks that you face will change as you move through your life cycle. Question: What are some examples of life cycle events that would effect your estimation of the risks in your life? Answer: Marriage, birth of a child, marriage breakup, children becoming independent, retirement, death of a spouse. Annual Reviews of your budget, insurance coverage and the changing risks around you should be an annual task. Summary 1. The 5 Steps of Risk Management: Identification, evaluation, control, financing and monitoring. 2. Evaluation of risk should be based on possible losses and the probability of the loss occurring. 3. Risk is managed with control techniques or financed using insurance. 4. Your risk profile should be reviewed annually, adjusting it based on changes in your life cycle.