RMIN4000 Test 1 UGA

Risk (Traditional Definition)

Uncertainty concerning the occurrence of a loss

Risk (Better Definition)

A calculated possibility of a negative outcome

Calculated Possibility

A probabilistic outcome (chance of loss, likelihood of loss) that is known or estimated | Ranges from 0 to 1 (0% to 100%)

Negative Outcome

Loss (Must be Quantifiable (in $))

Frequency

How often does a loss occur? • The number of losses (such as fire, theft, collision) that occur within a specified time period. • Probability of a loss. • Ex: Probability of a fire is 0.0071 per loss exposure per year.

Severity

How much does it cost when a loss does occur? • The dollar amount of loss for a specific peril (fire, theft, collision). • Example: Average structure fire loss is about $25,000

Frequency Equation

# of Losses / # of Exposures

Severity Equation

Total Losses ($) / # of Losses

Peril

Cause of Loss • Examples: Fire, windstorm, flood, collision, burglary, etc.

Hazard

A condition that creates or increases the frequency and/or severity of a loss. • Does not cause a loss. • Four types: 1. Physical 2. Moral 3. Morale (attitudinal) 4. Legal

Physical Hazard

A physical condition that increases the frequency and/or severity of a loss

Moral Hazard

The presence of insurance changes the behavior of the insured Examples • Using a hammer to create “hail” damage to a roof. • Exaggerating the value of the insured property.

Morale (Attitudinal) Hazard

Carelessness or indifference to a loss, which increases the frequency and/or severity of a loss. Examples: • Leaving car keys in an unlocked car. • Neglecting a tree limb growing over your roof.

Legal Hazard

Characteristics of legal system or regulatory environment that increase the frequency and/or severity of a loss. Examples: • Juries in some jurisdictions are more sympathetic than other areas (meaning larger damage awards in liability lawsuits). • Georgia now requires Diminution in Value to be paid on property losses (meaning increased severity in Georgia).

Risk Classifications

• Pure Risk vs. Speculative Risk • Diversifiable Risk • Nondiversifiable Risk • Enterprise Risk • Systemic Risk

Pure Risk

1) Loss 2) No Loss Ex: Auto Accident, Fire, Flood, Cancer, Slip & Fall

Speculative Risk

1) Loss 2) No Loss/No Gain 3) Gain Ex: Investment, Gambling

Diversifiable Risk

Affects only individuals or small groups, not the entire economy. • Can be reduced/eliminated through diversification. (Have multiple facilities, cloud/backup data centers) • Risks are not correlated (For example: fire at multiple locations, theft, vehicle collision).

Nondiversifiable Risk

Affects the entire economy or large numbers of groups/persons within the economy. • Cannot be reduced/eliminated through diversification. • Government assistance may be needed to insure. • Risks are correlated (inflation, unemployment).

Enterprise Risk

Encompasses all major risks faced by a business firm: • Pure Risk • Speculative Risk • Strategic Risk* • Operational Risk* • Financial Risk*

Systemic Risk

Risk of collapse of an entire system or entire market due to the failure of a single entity or group of entities that can result in the breakdown of the entire financial system. • Instability in the financial system due to the interdependency between the players in the market.

Major Types of Pure Risks

• Personal Risk • Property Risk • Legal Liability Risk • Loss of Business Income • Cyber-security

Personal Risk

Directly affects an individual or family; involves the possibility of loss of income, extra expenses, depletion of financial assets. What perils might be involved? • Premature Death • Unemployment • Disability/Injury/Poor Health • Inadequate Retirement Income

Property Risk

The possibility of losses associated with the destruction or theft of property.

Direct Loss (Property)

Cost to repair or replace property damaged by a peril.

Indirect Loss (Property)

Financial loss resulting as a consequence of a direct loss. Examples: • Fire damages your home, you have to pay to live elsewhere while it’s repaired. • Fire damages a business the firm experiences Business Interruption, Loss of Income, extra expenses et al.

Legal Liability Risk

Legal liability (financial consequences) resulting from injuries or damages you caused to someone else. • Defense costs • No cap on losses (in most situations) • Liens can be placed on income, assets seized.

Loss of Business Income

If a business has to shut down for a period of time due to a direct physical damage loss, it is unable to generate an income. • Is this a direct or indirect loss? • Example – Grease fire in the kitchen causes a restaurant to close down for 4 weeks while repairs are made. The restaurant has no income while closed, but certain expenses continue.

Burden of Risk On Society

• Larger Emergency Fund • Loss of Certain Good and Services • Worry and Fear

Techniques for Managing Risks

1. Risk Control 2. Risk Financing

Risk Control

Techniques to reduce the frequency or severity of losses

Risk Financing

Techniques for funding losses

Definition of Insurance

Insurance is the pooling of fortuitous losses by transfer of such risks to insurers, who agree to indemnify insureds for such losses, to provide other pecuniary benefits on their occurrence, or to render services connected with the risk

Basic Characteristics of Insurance

1. Pooling of losses 2. Payment of fortuitous losses 3. Risk Transfer 4. Indemnification

Law of Large Numbers

The greater the number of exposures, the more closely will actual results approach the probable results expected from an infinite number of exposures. • Example: A coin flip has a 50%/50% chance of heads o But you could flip it 10 times and get 8 heads (80%). o The more times you flip it, the closer the percentage of heads will get to 50%.

Pooling of Losses

The spreading of losses incurred by a few over the entire group. • Purpose is to reduce variation (as measured by standard deviation) which reduces uncertainty (risk). • Think of standard deviation as the average distance from the mean.

Fortuitous

unforeseen and unexpected by the insured and occurs a result of chance

Risk Transfer

Pure risk is transferred from the insured to the insurer, who typically is in a stronger financial position

Indemnification

The insured is restored to its approximate financial position prior to the occurrence of the loss

Characteristics of an IDEALLY Insurable Risk

1) Large number of exposure units. 2) Loss must be accidental and unintentional. 3) Loss must be determinable and measurable. 4) Loss should not be catastrophic. 5) Chance of loss must be calculable. 6) Premium must be economically feasible.

Large Number of Exposure Units

Enables the insurer to predict average loss based on the Law of Large Numbers. • Large number of similar exposure units needed.

Loss Must be Accidental and Unintentional

Loss should be outside of insured’s control Why? o Law of Large Numbers is based on randomness

Determinable Loss

Can you determine if a loss occurred?

Measurable Loss

Can you determine the amount of the loss?

Loss Should Not be Catastrophic (to the Insurer)

Allows pooling technique to work Examples of catastrophes • Terrorism • Hurricane / Named Windstorm • Flood • Earthquake

Chance of Loss Must be Calculable

Must be able to calculate average frequency and average severity

Premium Must be Economically Feasible

Insured must be able to afford it

Adverse Selection

The tendency of persons with a higher-than- average chance of loss to seek insurance at standard (average) rates, which, if not controlled by underwriting, results in higher than expected loss levels • Typically results from asymmetric information.

Asymmetric Information

Occurs when one party has information that is relevant to a transaction that the other party does not have.

Underwriting Risks

Process of selecting and classifying applicants for insurance • Standards met • Coverage terms/exclusions to consider • Rates

Types of Insurance

Private Insurance Government Insurance

Private Insurance

Life, Health, Property & Casualty

Government Insurance

Social insurance programs

Life Insurance

Pays a death benefit to beneficiaries when an insured dies

Health Insurance

Pays medical expenses because of sickness or injury. (Non work related injuries)

Property Insurance

indemnifies property owners against the loss or damage of real or personal property

Liability Insurance

covers the insured’s legal liability arising out of property damage or bodily injury to others

Casualty Insurance

broad term that refers to insurance that covers whatever is not covered by fire, marine, and life insurance. Frequently it includes auto, liability and workers’ compensation

Categories of Property & Liability Insurance

Personal Lines Commercial Lines

Personal Lines

• Private passenger auto • Homeowners’ “package” • Personal Umbrella Liability • Flood • Earthquake • Coastal Windstorm

Commercial Lines

• Commercial Auto • Workers’ Compensation • Commercial General Liability • Premise Liability • Products Liability • Commercial Umbrella / Excess Liability • Flood • Earthquake • Coastal Windstorm • Inland Marine / Ocean Marine • Surety Bonds • Fidelity Bonds / Employee Dishonesty • Crime • Cyber • Others

Government Insurance – Social Insurance Programs

Financed entirely or in large part by contributions from employers and/or employees • Benefits are heavily weighted in favor of low-income groups • Eligibility and benefits are prescribed by statute

Government Insurance – Social Insurance Programs Examples

1. Old-Age, Survivors, and Disability Insurance (Social Security) 2. Unemployment 3. Medicare

Other Government Insurance Programs

Found at both the federal and state level. • Examples o Federal Deposit Insurance Corporation (FDIC) o National Flood Insurance Program (NFIP) o Fair Access to Insurance Requirements Plans (FAIR) o Beach and Windstorm Plans

Risk Management

Process that identifies loss exposures faced by an organization and selects the most appropriate techniques for treating such exposures

Pre-Loss Objectives to RM

• Efficient cost of risk • Permits better decision making • Meet legal obligations

Post-Loss Objectives to RM

• Survival of firm • Business continuity, earnings, growth • Societal

Steps in the Risk Management Process

1. Identify loss exposures. 2. Measure and analyze the loss exposures. 3. Consider and select the appropriate risk management techniques. 4. Implement and monitor the chosen techniques.

Step 1: Identify Loss Exposures

• What assets need to be protected? • What perils are those assets exposed?

Important Exposures

• Property • Liability • Business Income • Human Resources • Crime • Employee Benefits • Foreign • Intangible • Regulatory

Sources for Identifying Loss Exposures

• Meeting with management including risk manager • Financial statements • Loss history • Other firms/competitors • Risk management consultants • Surveys/questionnaires • Site Inspections • Review sales and purchase agreements • Flowcharts

Step 2: Measure and Analyze the Loss Exposures

Estimate the frequency and severity of loss exposures. • Frequency (probability) – How often does the loss occur? • Severity (outcome) – How much does it cost when a loss does occur? Analyze • Rank loss exposures according to relative importance. • Severity is more important.

Maximum Possible Loss (MPL)

the worst loss that could happen to the firm during its lifetime

Probable Maximum Loss (PML)

the worst loss that is likely to happen.

Step 3: Consider and Select the Appropriate Risk Management Techniques

Risk Control Risk Financing

Risk Control

Techniques that reduce the frequency or severity of losses

Risk Financing

Techniques that provide for the funding of losses

Risk Control - Avoidance

A certain loss exposure is never acquired (proactive), or an existing loss exposure is abandoned (reactive)

Risk Control - Avoidance (Advantage)

Frequency is reduced to 0

Risk Control - Avoidance (Disadvantage)

• May not be possible. • Usually has an opportunity cost. • Avoiding one loss exposure may create another.

Risk Control – Loss Prevention

• Measures that reduce the frequency of a particular loss. • Does NOT completely eliminate risk.

Risk Control – Loss Reduction

• Measures that reduce the severity of a loss. • No effect on the frequency of a loss

Risk Control - Duplication

Having back-ups or copies of important documents or property available in case a loss occurs

Risk Control - Separation

Dividing the assets exposed to loss to minimize the harm from a single event. Examples: • Firewalls in buildings • Have multiple data centers or warehouses

Risk Control - Diversification

Reducing the chance of loss by spreading the loss exposure across different parties (customers, suppliers), securities (stocks, bonds), or transactions. Examples: • Expanding customer base • Using multiple suppliers

Risk Financing - Retention

A firm or individual retains part or all of the losses that can occur from a given risk • Retention level • Active • Passive

Retention level

the dollar amount of losses that the individual/firm will retain

Active

Deliberately retaining risk

Passive

Unknowingly retaining risk

When should risk be retained?

• No other option more attractive or available. • Worst possible losses are not serious (low severity). • Losses are predictable (high frequency; not catastrophic).

Risk Financing – Retention (Types)

• Unfunded; cash flow • Funded Reserve • Deductible • Captive Insurer • Self-Insurance Plan • Risk Retention Group / Group Captive

Risk Financing – Retention (Captive Insurance Company)

A captive insurer is an insurer owned by a parent firm for the purpose of insuring the parent firm’s loss exposures. • Single-parent captive is owned by only one parent. • Association or group captive is an insurer owned by several parents

Advantages of a Captive Insurance Company

• Can help a firm when insurance is too expensive or difficult to obtain. • Lower Costs o No agent or broker commissions. o Interest earned on invested premium. • Easier access to reinsurance market. • Possibility tax advantages. • Possibility of favorable regulatory environment.

Self-insurance

A special form of planned retention by which part or all of a given loss exposure is retained by the firm

Risk Retention Group

• Group captives that can write any type of liability coverage except employers’ liability, workers' compensation, and personal lines. • Exempt from many state insurance laws.

Risk Financing – Noninsurance Transfer

Methods other than insurance by which a pure risk and its potential financial consequences are transferred to another party. Examples • Contracts • Leases • Hold-harmless agreements

Risk Financing – Commercial Insurance

Appropriate for low-frequency, high-severity loss exposures These areas must be emphasized: 1. Selection of insurance coverages. 2. Selection of an insurer. 3. Negotiation of terms and services (risk control, claims, et al) 4. Dissemination of information concerning insurance coverages. 5. Periodic review of the insurance program.

Deductible

A specified amount subtracted from the loss payment otherwise payable to the insured

Excess insurance

A plan in which the insurer pays only if the actual loss exceeds the amount a firm has decided to retain

Manuscript policy

A policy specially tailored for the firm.

Risk Financing – Commercial Insurance (Advantages)

• Firm is indemnified for losses; can continue to operate • Uncertainty is reduced • Firm may receive valuable risk management services • Premiums are income-tax deductible

Risk Financing – Commercial Insurance (Disadvantages)

• Premiums may be more costly • Negotiation of policies takes time and effort • Most policies are annual • The risk manager may become lax in exercising loss control

Underwriting Cycles

Hard Insurance Market Soft Insurance Market

Hard Insurance Market

Insurer profitability is declining, underwriting standards are tightened, premiums increase, and insurance is hard to obtain

Soft Insurance Market

profitability is improving, standards are loosened, premiums decline, and insurance become easier to obtain

Step 4: Implement and Monitor the Chosen Techniques

Risk Management Policy Statement • Outlines o The risk management objectives of the firm. o The company policy with respect to treatment of loss exposures. • Provides standards for judging the risk manager’s performance.

Benefits of Risk Management

• Enables a firm to attain its pre-loss and post-loss objectives more easily. • Society benefits because both direct and indirect losses are reduced. • Can reduce a firm’s total cost of risk.

Traditional Risk Management

• Risks evaluated in a “silo” approach. • Loss exposures are usually insurable “pure” risks: o Property o Business Interruption o Liability o Personnel (for example, worker injuries)

Enterprise Risk Management

A strategic business discipline that supports the achievement of an organization’s business objectives by addressing the full spectrum of its risks and managing the combined impact of those risks as an integrated risk portfolio.

ERM Program

• Considers all risks an organization faces across the entire enterprise. • Holistic/interconnected view of risk. • Typically headed by Chief Risk Officer (CRO) and used in large organizations. • Creates a “risk culture” within the organization in which everyone is responsible for identifying and managing risk.

Aon 2021 Global Risk Report US Top 10

1. Cyber Attacks/Data Breach 2. Business Interruption 3. Economic Slowdown/Slow Recovery 4. Commodity Price Risk/Scarcity of materials 5. Damage to Reputation/Brand 6. Regulatory/Legislative Changes 7. Pandemic Risk/Health Crises 8. Supply Chain or Distribution Failure 9. Increasing Competition 10. Failure to Innovate/Meet Customer Needs

Allianz 2022 Risk Barometer Top 10

1. Cyber 2. Business interruption 3. Natural catastrophes 4. Pandemic 5. Changes to legislation and “ESG” (Environmental, Social & Governance) 6. Climate change 7. Fire, explosion 8. Market developments 9. Shortage of skilled workforce 10. Macroeconomic developments

Types of Risk within ERM

1) Hazard (Pure) Risk 2) Operational Risk 3) Financial Risk 4) Strategic Risk

Hazard (Pure) Risk

• Traditional Risk Management types of risks: • Property / Business Interruption • Liability • Personnel

What risk management techniques are used to treat hazard risks?

o Loss Prevention/Loss Reduction o Retention o Non-insurance risk transfer o Insurance

Operational Risk

Risks arising from day-to-day business operations Examples: • Cybersecurity • Supply Chain • Interruption of utilities • Manufacturing Defects • Customer Service • Employment practices and procedures

Financial Risk

Risks arising from changing conditions within financial markets: • Commodity Availability and Prices • Interest Rates • Credit Risk • Foreign Exchange Rates • Liquidity

Strategic Risk

• External • Little or no control over risk; must be in position to respond

Other Risks

• Regulatory/Compliance • Taxes • OSHA • SEC (Public companies) • Reputational • Terrorism • COVID • Climate Change

ERM Tools

• Risk Score • Risk Register • Risk Map

Advantages of an ERM Program

• Increase awareness and assessment of risk • Integrated response to the full range of risks • Alignment with organization’s risk tolerance and its strategies • Fewer operational surprises and losses • Greater compliance with regulatory and legal requirements • Improved accountability, efficiency and decision making • Increase value of the organization

Challenges / Barriers to an ERM Program

• Dynamic; always changing • Lack of commitment from senior leadership • Resistance to change / disagreement over responsibilities / turf war • Communication

Why should an organization use ERM?

By combining all risks into a single risk management program, the organization may be able to offset one risk against another and reduce its overall risk.

Insurance Market Dynamics

• Underwriting Cycles: • “Soft” markets • “Hard” markets • Insurer Combined Ratio • Insurer Investment Returns • Insurer Capacity / Surplus