INFORM+INSPIRE
Risk Management Principles
and
The Role of Insurance
David T. Russell, Ph.D.
Director, CSUN Center for Risk and Insurance
March 14-15, 2013
The Griffith Insurance Education Foundation
What is Risk?
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In short, Risk = Uncertainty
Two Kinds of Risk
 Pure Risk: Possibility of Loss
 Speculative Risk: Possibility of Profit or
Loss
 Example of Pure Risk: Driving a Car
 Example of Spec Risk: Buying a Stock
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Risk Management
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RM is Treatment of Exposure to Risk
Five Main Methods of Risk Management
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Avoidance (Refrain from Activity)
Retention (Accept the Possibility of Loss)
Loss Control (Steps to Reduce Freq or Sev)
Non-Insurance Transfer (ex: Hold Harmless)
Insurance (Transfer to a Pool for Premium)
Usually, RM is a Combination of Methods
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Insurance
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Insurance Transfers Risk to a Pool
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An Insurance Policy is a Contract
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“Shares” Risk with Other Similar Risks
Adjudicated and Regulated by State Law
Designed to Indemnify Policyholder
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“Insured” Should Not Profit from a Loss
Profiting from Loss Contrary to Public Policy
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The Insurance Purchase Decision
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One or More Reasons to Buy Coverage
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Required by Law, Lenders or Others
Buyer is Risk Averse or Unsure About Risks
Coverage is Mispriced (Rare)
One or More Reasons NOT to Buy
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Buyer Cannot Afford or Has Other Priorities
Coverage Perceived as too Expensive
Risk is Better Managed in Other Ways
Coverage Not Needed
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Insurance is NOT Gambling
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Insurance Transfers Existing Pure Risk
Gambling Creates New Speculative Risk
Insurer Reduces Risk by Pooling
Like Any Contract, Consideration a Must
Aleatory: Consideration is Unequal
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Underwriting
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UW is Selection/Classification of Risk
EQ Example for School
UW Uses Application, MVR, MIB, Other
Some UW Factors Illegal (Ex: Race)
Underwriters Place Risks in Right Pool
Insurer Loses $ if Many Risks Declined
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Moral Hazard
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Simply Put, Ins Changes Behavior
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Carelessness—Less Vigilant if Insured
Increased Utilization—Visit Doctor More
FDIC—Pursue High Rate, Despite Risk
Fraud—If Insured, Policyholder May
Intentionally Cause Losses to Collect Money
Result—Higher Claims
How to Prevent MH? Law, Contract, UW
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Adverse Selection
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AS is Tendency of Risks to Seek
Coverage at Lower Rates
Ex: “All-You-Can-Eat” Pricing
Ex: Unisex Pricing Option
Example: “No Medical Exam”
Result: Without Underwriting, Ins
Pools Tend to End Up With High Risks
Low Risks Tend to Drop Out
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The Insurance Mechanism
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Pooling of Similar Risks
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Ex: 10,000 Toyota Camrys
Using Historical Data, Losses Can Be
Predicted and Priced
Appropriate Insurance Concepts
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“Law of Large Numbers”
“In the Long Run”
“Diversified Portfolio”
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Insurable Risks
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Large Number of Exposures
Losses Are Accidental and Random
Losses Are Determinable & Measurable
Chance of Loss is Calculable (Pricing)
Premium is Economically Feasible
Losses Are Not Correlated*
Gov’t May Handle Uninsurable Risks
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The Insurance Mechanism
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Critical: Losses Cannot Be Correlated
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Correlated Risks: EQ, Flood, Unemploy Ins
Capital Required to Back Promises
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Losses Can Exceed Expectations
Usually, Capital is Called Equity or Net Worth
Insurer Capital is Called “Surplus”
Surplus is Cushion Against Unexpected
Surplus Expects a Return in Normal Times
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Simplified Pricing Example
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10,000 Toyota Camrys
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Assume Avg Claim is $250 per 6 Months
Insurer Must Add Expenses and Profit
Assume 15% for Corporate/Underwriting
Assume 15% for Commission
Assume 5% for Profit
$250 + 35% = $337.50 Avg Per Six
Months (Some Drivers Pay More, Less)
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Other Pricing Considerations
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Claims or Expenses May Come in High
Owners Lose Money in “Bad” Periods
Insurers May Purchase Reinsurance
Insurer Receives Investment Income
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Premiums Received Before Claims Paid
Investment Holdings Regulated
Investment Risks Can Affect Solvency
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Rate Regulation
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CA Requires Prior Approval for Auto, HO
Market Forces Also Keep Rates Low
Mature Mkt Means Fierce Competitors
Consumers Benefit from Competition
Inadequate Rates Threaten Everyone
Insolvency Costs Spread to Other Cos.
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State Guaranty Fund Assessments
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Rate Regulation
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Pricing Reflects Costs and Market Structure
Ins “Cost” is a Forecast, Rather than Known
Pricing Should Not Be Unfairly Discriminatory
Rates Should Be Adequate, But Not Excessive
 Cover Claim Costs, Overhead and Profit
 Capital Will Go Elsewhere Without Profit
 Profit Should Be Commensurate with Risk
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Solvency Surveillance
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Solvency = Sufficient to Pay Claims
Surplus is Cushion Against Unexpected
Surplus Does Not Mean “Too Much” $
Reserves Mean $ for Expected Claims
Policyholders Trust Claims Will Be Paid
DOI Actuaries Review Reserves
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Reserves Reflect Estimated Claim Costs
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Solvency Surveillance:
What Can Go Wrong?
Assets
Liabilities
Cash
1,000,000
Unearned Premiums
Investments
9,000,000
Reserves
7,500,000
Surplus
2,000,000
Total
10,000,000
Total
500,000
10,000,000
Note: Insurance companies use different, more “stable”
accounting rules called Statutory Accounting.
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US Insurance Market
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Very Large and Mature; Little Growth
Divided into Two Main Sectors
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Property/Casualty Insurance
Life/Health (Includes Annuity Products)
Larger Organizations May Self Insure
to Avoid Profit and Expense Loadings
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2011 U.S. Net Premiums Written
$175B
$502B
P&C
Life
A&H
$576B
Source: SNL Financial, Inc.
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2011 P&C U.S. NPW by Line
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2011 Life/A&H NPW by Line
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The California Insurance Market
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CA Represents About 11.29% of US Mkt
$124.5b in Premiums Written (2011)
Roughly 200,000 Agents Licensed in CA
Roughly $2.3b in Premium Taxes Paid
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Policy Forms
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Standardized Contracts of Insurance
Vetted Over Decades of Litigation
Changes Require Approval by State
Interpreted in State Courts
Ambiguities Interpreted Against Insurer
Smaller Insurers License Forms from
ISO (Insurance Services Office), etc.
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Policy Forms
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Policies Include Insuring Agreement,
Definitions, Conditions, Exclusions, Etc.
Can Be Amended with Endorsements
Policy Provisions Designed to Reduce
Moral Hazard, Adverse Selection, Fraud
Ex: Mold Exclusion
Ex: Suicide Clause
Ex: Must Cooperate w/Investigators
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INFORM+INSPIRE
Any Questions?
Feel free to contact me:
David T. Russell, Ph.D.
California State University, Northridge
(818) 677-2438
David.Russell@csun.edu
The Griffith Insurance Education Foundation