Advanced
PowerPoint
Presentation
©2009 The National Underwriter Company
Dr. James Kallman, ARM
4-1
This Advanced PowerPoint
Presentation accompanies the
“Tools & Techniques of Risk
Management & Insurance”
textbook. Each of the 28
chapters in the textbook are
presented here in the following
sections:
Outline
Key concepts
Major sections
Chapter summary
©2009 The National Underwriter Company
Dr. James Kallman, ARM
4-2
Contents
Techniques of Risk Management & Insurance
Ch 1 Introduction to Traditional Risk Management……………1-5
Ch 2 Enterprise Risk Management…………………………….2-1
Ch 3 Risk Assessment: Identification…………………………..3-1
Ch 4 Risk Assessment: Quantification…………………………4-1
Ch 5 Overview of Risk Treatment Alternatives………………. 5-1
Ch 6 Non-insurance Transfer of Risk…………………………. 6-1
Ch 7 Insurance as a Risk Transfer Mechanism……………….7-1
Ch 8 Overview of Alternative Risk Transfer Techniques……..8-1
Ch 9 Global Risk Management…………………………………9-1
Ch 10 Loss Control Techniques………………………………..10-1
Ch 11 Emergency Response Planning………………………..11-1
Ch 12 Business Continuity Planning…………………………..12-1
Ch 13 Claims Management……………………………………..13-1
Ch 14 Monitoring Claims for Financial Accuracy……………..14-1
Ch 15 Insurance Companies and Risk Management………..15-1
Ch 16 Working with an Agent or Broker……………………….16-1
©2009 The National Underwriter Company
Dr. James Kallman, ARM
4-3
Contents
Tools of Risk Management & Insurance
Ch 17 Commercial General Liability Insurance……………….17-1
Ch 18 The Workers’ Compensation System………………….18-1
Ch 19 Commercial Property Insurance………………………..19-1
Ch 20 Directors and Officers’ Liability Insurance……………..20-1
Ch 21 Employment-Related Practices Liability Insurance…..21-1
Ch 22 Business Automobile Insurance………………………..22-1
Ch 23 Crime Insurance………………………………………….23-1
Ch 24 Capital Markets Risk Transfer Tools…………………..24-1
Ch 25 Loss Control Tools……………………………………….25-1
Ch 26 The Certificate of Insurance…………………………….26-1
Ch 27 Surety Bonds……………………………………………..27-1
Ch 28 Claim Reviews……………………………………………28-1
©2009 The National Underwriter Company
Dr. James Kallman, ARM
4-4
Chapter 4
Risk Assessment: Quantification
Outline
• What is it?
• Step One: Determining Frequency versus Severity
• Step Two: Quantifying Retained Risk
• Step Three: Property Exposures
• Step Four: Considering Other Factors
• Advantages and Disadvantages
• Chapter Summary
©2009 The National Underwriter Company
Dr. James Kallman, ARM
4-5
Chapter 4
Risk Assessment: Quantification
What is it?
• Risk assessment includes risk identification and quantification
• Risk quantification is an extremely inexact science
• The purpose of risk quantification is
to determine the optimal amount of retained losses
• Optimization assumes:
• Insurance costs are optimized, and
• retained loss costs are reasonably predictable
• The risk quantification process compares exposure values to :
• loss frequency and loss severity, and
• the cost of insurance
©2009 The National Underwriter Company
Dr. James Kallman, ARM
4-6
Chapter 4
Risk Assessment: Quantification
What is it?
Supplement
• Two types of risk assessment
• Quantitative
• Qualitative
• Quantitative
• Measures exposure’s value
• expected outcome
• associated possible changes in value
• likelihood of each possibility over time
©2009 The National Underwriter Company
Dr. James Kallman, ARM
4-7
Chapter 4
Risk Assessment: Quantification
What is it?
Supplement
• Valuable information obtained
• Time of the occurrence
• Length or duration
• Expected outcome (arithmetic mean)
• Mode
• Median
• Standard deviation from the mean
• Range
• Coefficient of variation
©2009 The National Underwriter Company
Dr. James Kallman, ARM
4-8
Chapter 4
Risk Assessment: Quantification
What is it?
Supplement
• Loss triangulation
• An important tool in forecasting ultimate loss values
• Different meaning for “terms of art” across disciplines
• To avoid confusion…
• Exposures – changing the E in COPE to “”environment”
• Replacing “guaranteed cost” with “guaranteed rate”
• Using “self-funding” in place of “self insurance”
©2009 The National Underwriter Company
Dr. James Kallman, ARM
4-9
Chapter 4
Risk Assessment: Quantification
Step One: Determining Frequency vs Severity
• First analyze each exposure’s value
• Next determine the possible loss costs
• A general set of rules:
• retain smaller, frequent losses
• retain or transfer medium, more frequent losses –
depending on the cost of insurance
• transfer large (catastrophic) losses to an insurer
• The cost of insurance
• Don’t risk a lot for a little!
• Retain only what is cost effective
• Retention can be using a deductible or self-funding (SIR)
• The relationship between the premium and deductible is nonlinear. The incremental premium savings for a higher deductible
may not be worth the risk.
©2009 The National Underwriter Company
Dr. James Kallman, ARM
4-10
Chapter 4
Risk Assessment: Quantification
Step Two: Quantifying Retained Risk
• Techniques to determine how much to retain:
• Loss range analysis (stratification)
• Loss triangles
• Projected expected losses
• Loss Range Analysis
• An historical analysis of claims falling within ranges
• Use percent in each range to aid in selecting deductible
Simple loss Range Example
Total Number of Claims: 50
Years: 1996-2001
Loss Range
Claims Cum Claims % of Total
$1,000-$100,000
38
38
0.76
$100,001-$150,000
4
42
0.84
$150,001-$200,000
3
45
0.90
$200,001-$250,000
3
48
0.96
> $250,000
2
50
1.00
A company may choose to retain all losses <$200,001 (90% of total claims)
©2009 The National Underwriter Company
Dr. James Kallman, ARM
4-11
Chapter 4
Risk Assessment: Quantification
Step Two: Quantifying Retained Risk
• Loss Triangles
• The purpose is to determine the ultimate loss value (payment)
• The process is called loss development
• Historic data is used to determine loss development factors
• The factors are used to grow historic data to a forecast date
©2009 The National Underwriter Company
Dr. James Kallman, ARM
4-12
Chapter 4
Risk Assessment: Quantification
Step Two: Quantifying Retained Risk
• Develop a Loss Triangle - first start with the annual losses and
determine cumulative loss values ( see Fig. 4.3)
Creating a Loss Triangle
Losses Valued at Each Annual Interval
Accident Year
1996
Losses Limited to $250,000
Policy Year
1
2
3
4
5
(cumulative values developed at end of year)
Policy year losses:
Cumulative loss values:
100,000
100,000
25,000
125,000
35,000
160,000
15,000
175,000
55,000
230,000
(Assume claims are fully developed at end of policy year 5)
1997
Policy year losses:
Cumulative loss values:
150,000
150,000
10,000
160,000
60,000
220,000
30,000
250,000
(We need to calculate the growth to the end of year 5=
1998
Policy year losses:
Cumulative loss values:
220,000
220,000
20,000
240,000
60,000
300,000
(This data will be grown to year 4=
1999
Policy year losses:
Cumulative loss values:
190,000
190,000
)
9then year 5=)
45,000
235,000
(This data will be grown to year 3, 4, and then year 5)
2000
Policy year losses:
Cumulative loss values:
70,000 (this 1 value must be grown to year 5)
70,000
©2009 The National Underwriter Company
Dr. James Kallman, ARM
4-13
Chapter 4
Risk Assessment: Quantification
Step Two: Quantifying Retained Risk
• Loss Triangles - Now we determine each year’s growth factor
Creating a Loss Triangle
Losses Valued at Each Annual Interval
Accident Year
Losses Limited to $250,000
Policy Year
1
2
3
4
(cumulative values developed at end of year)
1996 Cumulative loss values:
Growth factor formulas
Factor values
1997 Cumulative loss values:
Growth factor formulas
Factor values
1998 Cumulative loss values:
Growth factor formulas
Factor values
100000
(n/a)
1999 Cumulative loss values:
Growth factor formulas
Factor values
190000
(n/a)
2000 Cumulative loss values:
70000
150000
(n/a)
220000
(n/a)
5
125000
160000
175000
230000
=125/100 =160/125 =175/160 =230/175
1.25
1.28
1.09
1.31
160000
220000
250000
=160/150 =220/160 =250/220
1.07
1.38
1.14
240000
300000
=240/220 =300/240
1.09
1.25
235000
=235/190
1.24
©2009 The National Underwriter Company
Dr. James Kallman, ARM
4-14
Chapter 4
Risk Assessment: Quantification
Step Two: Quantifying Retained Risk
• Loss Triangles - Next we calculate the average growth per year and then compound to get the ultimate growth factors
Creating a Loss Triangle
Losses Valued at Each Annual Interval
Policy Year
Losses Limited to $250,000
1
2
3
4
5
1.28
1.38
1.25
1.09
1.14
1.31
1.30
1.12
1.31
Accident Year
1996
1997
1998
1999
We assume a
simple average
is an appropriate
way to find the
average – other
methods exist!
Factor values
Factor values
Factor values
Factor values
Average Growth Factor
1.25
1.07
1.09
1.24
1.16
1996 Losses are fully developed at end of 5th year
1997 Losses at end of 4th year are grown by the average factor of
1.31
1998 Losses at the end of 3rd year are compounded by the 4th & 5th year factors
=1.12 x 1.31 =
1.47
1999 Losses at the end of 2nd year are compounded by the 3rd,4th, & 5th year factors
=1.30 x 1.12 x 1.31 =
1.91
2000 Losses at the end of the 1st year are compounded by all growth factors
=1.16 x 1.31 x 1.12 x 1.31 =
2.21
©2009 The National Underwriter Company
Dr. James Kallman, ARM
4-15
Chapter 4
Risk Assessment: Quantification
Step Two: Quantifying Retained Risk
• Loss Triangles - Now we calculate the ultimate payouts
Creating a Loss Triangle
Losses Valued at Each Annual Interval
Policy Year
Losses Limited to $250,000
1
2
3
4
Ultimate
Growth
Factor
n/a
1.31
1.47
1.91
2.21
5
Ultimate
Payout
230,000
328,571
439,651
448,285
166,119
Dr. James Kallman, ARM
4-16
Accident Year
1996
1997
1998
1999
2000
Losses (cum)
100,000
150,000
220,000
190,000
75,000
125,000
160,000
240,000
235,000
160,000
220,000
300,000
©2009 The National Underwriter Company
175,000
250,000
Chapter 4
Risk Assessment: Quantification
Step Two: Quantifying Retained Risk
• Projected Expected Losses - Finally we adjust for inflation
(Inflation factors can be obtained from BLS)
Creating a Loss Triangle
Adjusting Ultimate Payouts for Inflation
(Answers differ from fig 4.4 due to rounding in text)
Policy Year
5th Year Inflation Trended,
Accident Year
Ultimate
Growth Ultimate
Payout
Factor
Losses
1996
Losses (cum)
230,000
1.15
264,500
1997
328,571
1.13
371,286
1998
439,651
1.10
483,616
1999
448,285
1.08
484,148
2000
166,119
1.00
166,119
We have quantified the ultimate losses for operations in each year. We use this
expected loss value in our budgets and for allocating resources.
Important note: other valid loss triangle development methods exist!
©2009 The National Underwriter Company
Dr. James Kallman, ARM
4-17
Chapter 4
Risk Assessment: Quantification
Step Three: Property Exposures
• Property exposure loss quantification uses a different method to
quantify the loss values
•Property losses usually develop to their ultimate value within one
operating period
• Three loss values are estimated:
• mean value ( E(L), L, x ,  )
(or mode or median loss value from historic data)
• Maximum possible loss (MPL)
(worst case scenario – building burns to the ground!)
• Probably maximum loss (PML)
(realistic worst case scenario –the fire department will respond)
• Prior to 9/11 the MPL was rarely considered
©2009 The National Underwriter Company
Dr. James Kallman, ARM
4-18
Chapter 4
Risk Assessment: Quantification
Step Four: Considering Other Factors
• Three additional factors should be considered in quantifying
the risks:
• Impact of Actuarial Credibility on Insurance Pricing
• Cash flow Analysis
• Benchmarking
©2009 The National Underwriter Company
Dr. James Kallman, ARM
4-19
Chapter 4
Risk Assessment: Quantification
Step Four: Considering Other Factors
• Impact of Actuarial Credibility on Insurance Pricing
• Actuaries use confidence intervals to provide a range of
outcomes about the mean value.
• Actuaries have access to industry data to add validity to a
company’s historic data
• They use the confidence level to add a built in swing to create a
maximum premium for loss sensitive plans
Actuary’s loss probability distribution
Mean
(Mean+1 std dev) = swing
©2009 The National Underwriter Company
Dr. James Kallman, ARM
4-20
Chapter 4
Risk Assessment: Quantification
Step Four: Considering Other Factors
• Cash flow Analysis
• A CF analysis represents the true long-term value (NPV)
• An analysis is done on the two main types of risk financing
• Guaranteed Rate Insurance
• Self-funded combined with Excess Insurance
Guaranteed Rate Insurance
The rate per exposure unit is guaranteed at the policy
inception. At expiration an audit on the exposure basis
is done. The guaranteed rate is applied to the actual
exposure basis (also called a guaranteed cost). The
deposit premium paid at inception has no cash flow
benefits. If paid over time the cash flows are discounted
to the present value – creating a CF benefit
©2009 The National Underwriter Company
Dr. James Kallman, ARM
4-21
Chapter 4
Risk Assessment: Quantification
Step Four: Considering Other Factors
• Cash flow Analysis
• Guaranteed Rate Insurance example:
Inception: Est. Exposure basis ($11M limit)
Guaranteed rate/exp
Deposit premium
Expiration: Audited actual exposure basis
Guaranteed rate/exp
Final premium
Additional premium due
Discount rate (cost of capital)
Present value of cash flow
Cash flow benefit
©2009 The National Underwriter Company
2000 units
$200/unit
$400,000
2300 units
$200/unit
$460,000
$ 60,000
8.5%
$ 55,300
$ 4,700
Dr. James Kallman, ARM
4-22
Chapter 4
Risk Assessment: Quantification
Step Four: Considering Other Factors
• Cash flow Analysis
•Self-funded with Excess Insurance
A retention of first dollar losses combined with
insurance over (excess of) the retained layer. The
retention relieves the payment of the first layer premium
Example:
Self-funded retention, E(L)
Excess insurance $10M limit
Estimated average time to payment
PV of cash flows (r = 8.5%)
-100,000 + {1M/(1.085^.75)}
Cash flow benefit
©2009 The National Underwriter Company
$1,000,000
$ 100,000
9 mo
$1,040,649
$ 959,351
Dr. James Kallman, ARM
4-23
Chapter 4
Risk Assessment: Quantification
Step Four: Considering Other Factors
• Cash flow Analysis
• Benchmarking
• Comparing one company’s cost of risk to others (industry)
• A cost of risk includes:
• Retained loss costs
• Insurance premiums
• Risk control costs
• Administrative costs
• Cost-of-Risk benchmark studies are available from RIMS
• Caveats
• Assumes the industry is at a desired equilibrium
• Assumes risk financing strategy is to follow others
©2009 The National Underwriter Company
Dr. James Kallman, ARM
4-24
Chapter 4
Risk Assessment: Quantification
Advantages and Disadvantages
+
+
+
Impact of Risk on Financial Health
Good risk financing plans are essential to meet shareholders’
expectations
Excessive risk aversion (excessive insurance) decreases
shareholder value
Avoiding risks = avoiding opportunities to create shareholder
value
Quantifying the risks helps to understand which risks (and
rewards) to accept and which risks to avoid
Quantification aids in retaining the optimal level of risk
financing and determining when to transfer to an insurer
©2009 The National Underwriter Company
Dr. James Kallman, ARM
4-25
Chapter 4
Risk Assessment: Quantification
Chapter Summary
• What is it?
Measuring the risks and determining the optimal
retention/insurance financing
• Step One: Determine Frequency versus Severity
Plot risks on a frequency:severity map
• Step Two: Quantifying Retained Risk
Use Loss range analysis (stratification), Loss triangles, &
Projected expected losses – used in casualty lines
• Step Three: Property Exposures
Short-term cash flow analysis with consideration for the MPL
• Step Four: Considering Other Factors
Actuarial modeling, Cash flow Analysis, & benchmarking
• Advantages and Disadvantages
Proper quantification leads to efficient risk financing and
creating shareholder value
©2009 The National Underwriter Company
Dr. James Kallman, ARM
4-26