Risk Management Final Review – Flashcards

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What is risk?
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The uncertainty concerning the occurrence of a loss
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Types of Risk
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Objective Subjective Pure Speculative Fundamental Particular Enterprise
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Objective Risk
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Relative variation of the actual loss from the expected loss Example: A prorpety insurer insures 10,000 homes with an expected loss of 100 homes to burn each year. However, the actual number of homes varies from 90-110. (The actual can be more or less than the expected) To find the objective risk you take the variation amount and divide by expected loss [variation/E(L)] Objective risk declines as the number of exposures increase - Law of Large Numbers
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Law of Large Numbers
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As the number of exposure units increase, the actual loss will approach the expected loss more closely
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Subjective Risk
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Uncertainty based on person's mental condition or state of mind High subjective risk, then the person takes a conservative & prudent behavior
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Pure Risk
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Loss or no loss Adverse or neutral Types: Personal Property Liability
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Personal Pure Risks - Premature Death
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Premature Death - a death of a family-head with unfulfilled financial obligations This is based off of 4 characteristics (1) Human Value of Life - The present value of deceased breadwinner's future earnings (2) Additional Expense (3) Trouble making ends meet (4) Non-economic costs
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Personal Pure Risks
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Risk of Insufficient Income During Retirement Risk of Poor Health - Payment of catastrophic medical bills -Loss of earned income Risk of Unemployment - Usually due to a business cycle (1) Lose Income (2) Only can work part-time job (3) Past savings & unemployment benefits have been exhausted
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Property Pure Risks
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Property - property damaged or lost Direct - a result from a physical damage, destruction or theft of the property Indirect - results indirectly from direct losses There also can be added expenses that occur from either the indirect and/or direct losses
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Liability Pure Risk
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Liability Risk - legally liable if you do something that results in bodily injury or property damage to someone else (1) No maximum upper limit with respect to the amount of the loss (2) A lien may be placed on your income of financial assets to statsify legal judgement (3) Legal defense can be enormous
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Speculative Risk
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A situation in which either profit or loss is possible Examples: Stock market, betting on horse racing
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Pure Risk v. Speculative Risk
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(1) private insurers invest in pure risk (2) Law of large numbers applies only to pure (3) Society may benefit from a speculative risk even if a loss does occur Example of #3: New technology
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Fundamental Risk
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Affects the entire economy or a large number of people/groups within the economy Examples: Unemployment, War
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Particular Risk
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Affects only individuals
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Fundamental Risk vs. Particular Risk
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Government insurance is provided under fundamental risk Example: Flood Insurance
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Enterprise Risk
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All major Risk faced by a business this includes: Pure Risk Speculative Risk Strategic risk Operational Risk Financial Risk
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Strategic Risk
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Uncertainty regarding financial goals & objectives
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Operational Risk
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Uncertainty regarding a firms business operations
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Financial Risk
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Uncertainty regarding the loss because of adverse changes in commodity prices, interest rates, exchange rates and value of monies
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Chance of Loss
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The probability an event will occur. There are two types: Objective Probability Subjective Probability
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Objective Probability
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Long run frequency that given infinite observation and no changes, a loss will occur Deductive Reasoning - a priori probabilities Example: A coin getting a head is 1/2 Inductive Reasoning Example: How much coverage a 21 year old needs for a 5 year life insurance plan
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Subjective Probability
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An individual's personal estimate of a chance of loss Example: Someone believing they are extra lucky because it is their birthday
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Peril
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The cause of a loss; the COD on a death certificate Example: Fire, collision
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Hazard
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A condition that increases or creates the chance of a loss Types: Physical Moral Morales Legal
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Physical Hazard
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A physical condition that increases the chance of loss Example: A patch of ice
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Moral Hazard
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Dishonesty or a character defect Wince people LIE to insurance companies, premiums are higher for everyone Example: falsely reporting claims
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Morale Hazard
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Carelessness or indifference because the person has insurance Example: leaving valuable in a unlocked car
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Legal Hazard
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Legal system or regulatory environment Example: adverse jury verdicts,
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Enterprise Risk Management
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Combining a single unified treatment program to deal with all sorts of risk
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Risk: Burdens on Society
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(1) Emergency fund size must be increased (2) Society is deprived of certain goods and services (3) Worry and Fear are present
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How to Handle Risk
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(1) Avoidance (2) Loss Control (3) Retention (4) Non-Insurance Transfer (5) Insurance
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How to Handle Risk: Loss Control
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Loss Control - certain activities that reduce severity and frequency of loss - Loss Prevention - reducing PROBABILITY of loss, the frequency is reduced - Loss Reduction - reduce SEVERITY of a loss after it occurs Desirable: (1) Indirect loss >= direct loss (2) Social cost of loss reduced
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How to Handle Risk: Retention
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Retention - retains all or part of the given risk - Active Retention - consciously aware of the risk (1) Save Money (2) Insurance is unavailable/unaffordable - Passive Retention - unknowinlgy retained (1) ignorance, indifference or laziness
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How to Handle Risk: Non-Insurance Transfer
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Transferred to a party other than the insurance company Can do this through: (1) Contracts - hold-harmless clause - contract in which one party agrees to indemnify the other (2) Hedging - forward purchase that locks in good or service over an extended period (3) Incorporation of a business - personal assets cannot be attached to a creditor
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How to Handle Risk: Insurance
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(1) Risk Transfer (2) Pooling technique (3) Reduced by the Law of Large Numbers
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Insurance
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Pooling of fortuitous losses by transfer of such risk 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 risks
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Characteristics of Insurance - Pooling of Losses
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Pooling of losses = sharing the losses Spreading the losses incurred by the FEW over an ENTIRE group so that in the process, the AVERAGE loss is substituted for ACTUAL losses Implies: (1) Sharing losses by entire group (2) Prediction of future losses with accuracy If future loss can be priced predicted, the objective risk goes down
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Characteristics of Insurance - Payment of Fortuitous Losses
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A loss that is unforeseen or unexpected and occurs as a result of chance
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Characteristic of Insurance - Risk Transfer
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Pure risk (yes/no) is transferred from insured to insurer, who is typically in a stronger position to pay the loss than the insured
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Characteristic of Insurance - Indemnification
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Indemnification - the insured is made whole - restored to approximate financial position prior to occurrence of the loss
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What Makes a Risk Insurable?
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(1) Large Number of Exposure Units (2) Must be accidental and unintentional (3) Determinable & Measurable (4) Not catastrophic (5) Must be calculable (6) Economically feasible
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Not Catastrophic
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Ways to combat catastrophic risks Reinsurance - is an arrangement by which the primary insurer that initially writes the insurance transfers to another insurer part or all of the potential losses Disperse coverage over a large geographical area
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Adverse Selection
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The tendnecy of persons with higher than average chance of loss to seek insurance at a standard rate Controlled by: (1) Underwriting - process of selecting and classifying applicants for insurance If it's NOT MET - denied or pay an extra premium (2) Policy Provisions Example: Suicide clause
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Gambling vs. Insurance
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Gambling - creates a new speculative risk Insurance - is a technique for handling an already existing risk Gambling is socially unproductive beceuse the winner gains at the expense of the loser Insurance is ALWAYS socially productive
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Insurance v. Hedging
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(1) Insurance - involves transfer of insurable risk Hedging - technique for handling risks that are typically un-insurable (2) Insurance can reduce the objective risk of an insurer by application of the law of large numbers Hedging is only a RISK TRANSFER, not reduction
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Types of Insurance
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Private - Health & Life - Property & Liability - Property & Casualty - Personal Lines - Commercial Lines Government - Social Insurance
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Private Insurance
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Private - Health & Insurance - Life Insurance - Pays death benefits to designated beneficiaries when the insured dies Examples: funeral expenses, un-insured medical bills, estate taxes -Property & Liability - Property - indemnifies property owner against the loss or damage of real/personal property Liability - covers insured's legal liability arising out of property damage or bodily injury to others - Property & Casualty Casualty Insurance - A Broad field of insurance that covers whatever is not covered by fire, marine & life insurance (1) Personal Lines - coverages that insure the real estate and personal property of individuals and families Examples: - private passenger auto insurance - homeowners insurance - personal umbrella liability insurance - Boat owners insurance (2) Commercial Lines - property & casualty insurance for business firm, non-profits and government agencies Examples: - Fire Insurance - Commercial multi-peril insurance - General Liability - Workers Compensation - Commercial Auto insurance - Accident & Health Insurance
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Government Insurance
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Social Insurance - a government insurance program with certain characteristics that distinguish them from other government plans (1) funded by mandatory contributions (2) right to receive benefit is ordinarily derived from recipients past contribution Examples: Social Security, Medicare, Workers Compensation, Disability Act
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Benefits of Insurance to Society
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(1) Indemnification for loss - As a result, can maintain financial secuirty (2) Reduction of worry & fear - Before AND after loss occurs (3) Source of investment funds - Increases society's stock of capital goods which promotes economic growth and full employment (4) Loss prevention - reduces both direct and indirect losses (5) Enhancement of credit - greater assurance that the loan will be repaid
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Cost of Insurance to Society
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(1) Cost of Doing Business - consume scare economic resources - expense loading - the amount needed to pay for ALL expenses; this is justified by: - uncertainty concerning the payment of a covered loss - insurers engage in a wide variety of loss prevention activities - provides jobs (2) Fraudulent Claims - results in higher premiums to all the insureds (3) Inflated Claims - Also Known As: Padded Claims - the dollar amount of a claim may exceed the financial loss - results in higher premiums, reduction of disposable income and consumption of goods/ services
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Risk Management
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The process that identifies loss exposures faced by an organization & selects the most appropriate techniques for treating such exposure
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Loss Exposure
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Any situation in which a loss is possible, regardless of whether a loss occurs
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Risk Management Objectives
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(1) Pre-loss Economy - what will happen Reduction of anxiety Meeting legal obligations (2) Post-loss Survival of the firm Continue Operating Stability of Earnings Continued Growth Minimize the effects that a loss will on have other persons & society
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Risk Management Process
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(1) Identify loss exposure (2) Analyze the loss exposure (3) Select appropriate techniques for treating loss Risk Control - avoidance - prevention - reduction Risk Financing - retention -non-insurance transfers -insurance (4) Implement & monitor the risk management program
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Identifying Loss Exposures
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Types of exposures: Physical Liability Business Income HR Crime Loss Employee Benefit Foreign Loss Exposure Public Image of Company ALSO: PHYSICAL INSPECTION FINANCIAL STATEMENTS/RECORDS HISTORICAL LOSS DATA CONTRACT ANALYSIS FLOW CHARTS LISTS
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Analyze the Loss Exposures
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Loss Frequency - the probable number of losses that may occur during some given time period Loss Severity - probable SIZE of the loss that may occur Maximum Probable Loss - Worst likely Maximum Possible Loss - Worst possible
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Selecting Appropriate Techniques to Treat the Loss
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Risk Control - reduces the frequency & severity of loss -Avoidance -Loss prevention -Loss reduction -- duplication/separation Risk Financing -Retention -Non-insurance transfer -Insurances
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Retention
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Retention level - the dollar amount of losses that the firm will retain -Maximum retention = 5%(Annual Earnings) -Maximum retention = 5%(Net Working Capital) Unfunded vs. Funded - Unfunded - bookkeeping account that is charged with actual or expected losses from a given exposure -Funded - setting aside of liquid funds to pay losses Credit Line - From the Bank, borrowed funds may be used to pay losses as they occur, but you HAVE TO PAY INTEREST ON LOANS
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Self-Insurance
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A special form of planned retention by which part or all of a given loss exposure is retained by the firm SELF FUNDING
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Retention Advantages
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Saves money Lower expenses Encourages loss prevention Increases cash flow
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Retention Disadvantages
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Possible higher losses Possible higher expenses Possible higher taxes
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Non-Insurance Transfers
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Methods other than insurance by which a pure risk and its potential finial which a pure risk an dits potential financial consequences are transferred to another party Examples: Contracts Lease Hold-Harmless Agreements
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Insurance
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Captive Insurer - An insurer owned by a parent firm for the purpose of insuring the parent firm's loss exposure -pure captive - one parent -group captive - several parents
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Why are captive insurers formed?
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(1) Difficulty obtaining insurance (2) Lower costs (3) Easier access to reinsurer (4) Formation of a profit center
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Insurance Steps
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(1) Is Coverage Needed? (2) What should the deductible be? (3) Select insurer (4) Terms of Insurance are negotiated Manuscript policy (5) REVIEW!
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Deductible
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A Provision by which a specified amount is subtracted from the loss payment otherwise payable to the insured ELIMINATES SMALL CLAIMS
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Insurance Advantages
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Indemnified after a loss occurs Uncertainty reduced Valuable risk management services Income-tax deductible
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Insurance Disadvantages
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Payment of premiums are high High time/effort costs Less incentive to follow loss control program since insurance is in place
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Implement & Monitor the Risk Management Program
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Risk Management Policy Statement - outlines risk management objectives of firm Risk Management Manual - describes IN DETAIL the risk management program of the firm
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Personal Risk Management
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Same steps as Commercial Refers to the identification of pure risks faced by an individual or family & to the selection of the most appropriate technique for treating such risk
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Legal Principles of Insurance
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Indemnity Principles of Insurable Interest Subrogation Principles of Utmost Good Faith
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Indemnity
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The insurer agrees to pay no more than the actual amount of the loss; THERE IS NO PROFIT FROM A LOSS Helps to reduce moral hazard Actual Cash Value - Replacement cost - depreciation - Fair Market Value = price a willing buyer would pay a willing seller in a free market Example: E-bay
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Exceptions to Principle of Indemnity
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(1) Valued Policy - policy that pays the face amount of insurance if a total loss occurs (2) Replacement Cost Insurance - no deduction for physical depreciation in determining the amount paid for a loss
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Principles of Insurable Interest
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Insured must be in a position to lose financially if a loss occurs Purpose: - prevent gambling - reduce moral hazards - measure amount of loss in property insurance Required: - Property Insurance: at the time of a loss - Life Insurance: must be met only at the INCEPTION of the policy NOT the time of death
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Subrogation
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A substitution of the insurer in place of the insured for the purpose of claiming indemnity from a 3rd person When/How does subrogation happen? - after payment to insured - insurer attempts to recover payment from responsible party Purposes: (1) prevents from collecting twice on same loss (2) Used to hold the negligent person responsible for the loss (3) Hold down insurance rates
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Principles of Utmost Good Faith
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Higher degree of honesty is imposed on parties to other contracts Justification - high degree of information asymmetry
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Elements of Utmost Good Faith
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(1) Representations - statements made by applicant for insurance; contract voidable at insurer's option if: - material: if insurer knew true facts, the policy would not have been issued or would have been issued differently - False - misleading - Relied on by the insurer (2) Concealment - intentional failure of the applicant for insurance to reveal a material fact to the insurer - non-disclosure - element of deception Test for Concealment - Did insured know of a certain fact? - Was the fact material? - Was the insurer ignorant of the fact? (3) Warranties - Statement that becomes part of the insurance contract and is guaranteed by the maker to be true in all aspects Types: - promissory - condition to continue throughout contract period - affirmative - exists at contract's inception; promises nothing in the future
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Utmost Good Faith
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Insured can SUE INSURER - Known as the bad faith claim - used when insured feels insurer is not actin gin good faith; this forces companies to perform according to contract
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Requirement Of An Insurance Contract
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(1) Offer/Acceptance - applicant makes offer, insurer accepts/reject it Binder - a temporary contract for insurance; can be oral or written (2) Consideration - value each party gives the other Insured - payment of premium Insurer - specified in contract (3) Competent Parties - must have legal capacity to enter into a binding contract NOT OKAY: insane, mentally handicapped, intoxicated or minors (4) Legal Purpose
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Distinct Legal Characteristics of Insurance Contracts
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(1) Aleatory - a contract where values exchanged may not be equal but depend on an uncertain event (2) Communicative - values of exchange ARE equal (3) Unilateral - only one party makes a legally enforceable promise (4) Conditional - Insurance company's obligation to pay a claim DEPENDS on whether the insured or beneficiary has complied with all policy conditions Conditions - provisions inserted in the policy that qualify or place limitations on the insurers promise to perform (5) Personal - Contract between insured and insurer (6) Contract of Adhesion - Must accept the ENTIRE contract, with all of its terms and conditions TAKE IT OR LEAVE IT
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Principle of Reasonable Expectation
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An insured is entitled to coverage under a policy that he/she reasonably expect it to provide
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Insurance Company Operations
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Rate Making Underwriting Production Claim Settlement Reinsurance Investments Other Insurance Company Functions
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Rate Making
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Price of insurance Does not know in advance what actual costs will be Actuaries - determine rates and premiums. The goal is to set pricing to make company profitable and competitive (1) Set appropriate classes (2) Develop reliable loss data for each class (3) Convert data to develop final premium Exposure Unit - unit of measurement used in insurance pricing Extremely technical Selection of classs os exposure units which collect statistics regarding probability and severity of loss
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Rate Making Formula
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Gross Premium = pure premium + (expense loading ratio x gross premium) Gross Premium = pure premium /[1 - expense loading ratio] Pure premium = Expected loss/ # of exposure units
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Gross Premium Rate Determinants
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Present value of expected claims Present value of expense lading: Administration costs Profit Loading - return/reward to investors for providing capital Investment income - premiums decrease by amount of investment Income earned on premiums *** as interest rates go up, premiums go down***
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Underwriting
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The process of selecting, classifying, and pricing applicants for insurance Line underwriter - person who makes daily decisions concerning the acceptance or rejection of business
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Underwriting Principles
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(1) Must select prospective insureds according to the company standard (2) Proper balance within each rate classification to help reduce adverse selection (3) Equity among policy holders (4) Balancing act - attain an underwriting profit
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Steps in Underwriting
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(1) Field Underwriting - which applications are acceptable (2) Sources of underwriting information - Application - Agent Report - evaluation of prospective insured - Inspector Report - outside firm investiages the applicant for insurance - Physical Inspection - Physical Examination - MIB (Medical Information Bureau)
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Underwriting Cycle
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Hard Markets - high premiums, tight standards, not affordable Soft Markets - Low premiums, loose standards, better for customer Insurance Industry Capacity - - Capacity - relative level of surplus; the greater the surplus, higher willingness to write new businesses/reduce premiums; maximum amount insurance can coverage
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Combined Ratio
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Ratio of paid losses and loss adjustment expenses plus underwriting expenses to premiums CR = [losses + loss adjustment exp + underwriting expense]/premiums ratio > 1 UNPROFITABLE ratio < 1 profitable
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Insurance Company Profitability
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Underwriting Premiums + Investment Revenue - Expenses (Losses, Loss Expenses & Underwriting Expenses) = Company Profit
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Production
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Sales & marketing activities of insurers Known as producers - agents who sell insurance Agent - competent professional with a high degree of technical knowledge in a particular area of insurance and places the needs of the clients first Special Agent - highly specialized technician who provides local agents in the field with technical help and assistance with their marketing problems
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Claim Settlement
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Objectives: Verification a covered loss occurred Fair & prompt payment of claims Personal assistance to the insured
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Unfair Claim Practices
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(1) Refusing to pay claims without conducting a reasonable investigation (2) Not attempting in good faith to provide prompt, fair & equitable settlements of claims (3) offering lower settlements to compel insureds to institute lawsuits to recover amounts due
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Types of Claims Adjustors
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Agent - authority to settle small first-party claims Company - a salaried employee who represents just one company Independent - a person who offers services to insurance companies and is compensated by a fee
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Steps in a Claims Process
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(1) Notice of loss - notify insurer (2) Investigation of claim - covered loss has occurred? amount? (3) Filing a proof - proof of loss - sworn statement by the insured saying that substantiates the loss (4) Decision Concerning payment -Paid -Denied -Valid, but dispute over HOW MUCH Policy provisions are set in place on how to deal with the dispute
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Reinsurance
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Arrangement by which the primary insurer transfer to another insurer part or all of the potential losses associated with such insurance Ceding company -primary insurer who writes business Re-insurer - insurer that accepts insurance from ceding company Retention Limit - amount of insurance retained by ceding company Cession - amount of insurance ceded to re-insurer
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Reasons for Reinsurance
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(1) Increase underwriting capacity - write new business (2) Stabilize profits - avoid large fluctations due to adverse loss conditions (3) Reduce unearned premium reserve Unearned portion of gross premiums on all outstanding policies at the time of valuation (4) Provide protection against catastrophic loss (5) Retire from business, line of insurance, or territory (6) Obtain underwriting advice on a line for which an insurer has little experience
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Types of Reinsurance
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Facultative - case by case method that is used when the ceding company receives an application for insurance that EXCEEDS retention limit Advantage - flexibility Disadvantage - uncertainty Treaty Reinsurance - primary insurer has agreed to cede insurance to re-insurer and re-insurer has agreed to accept it
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Methods of Loss Sharing
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Pro-rata - ceding company & re-insurer agree to share losses and premiums Excess Method - re=insurer pays ONLY when covered losses exceed a certain level Quota-Sharing Treaty ceding insurer and re-insurer agree to share premiums and losses base don some proportion Ceding commission
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Investments
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Premiums paid in advance, invested until needed Investment income - reducing cost of insurance (1) Long term - life; safety of principal's primary consideration (2) Short term - property; payments vary widely depending on losses
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Other Insurance Company Function
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EDP - Electronic Company Function Accounting Department legal Department Loss - control Services
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