INFORM+INSPIRE The Griffith Insurance Education Foundation Risk Management Principles and The Role of Insurance David T. Russell, Ph.D. Director, CSUN

INFORM+INSPIRE

The Griffith Insurance Education Foundation

Risk Management Principles and

The Role of InsuranceDavid T. Russell, Ph.D.

Director, CSUN Center for Risk and Insurance

March 14-15, 2013

What is Risk? 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


Risk Management RM is Treatment of Exposure to Risk Five Main Methods of Risk Management

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


Insurance

Insurance Transfers Risk to a Pool “Shares” Risk with Other Similar Risks

An Insurance Policy is a Contract Adjudicated and Regulated by State Law

Designed to Indemnify Policyholder “Insured” Should Not Profit from a Loss Profiting from Loss Contrary to Public Policy


The Insurance Purchase Decision

One or More Reasons to Buy Coverage 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 Buyer Cannot Afford or Has Other Priorities Coverage Perceived as too Expensive Risk is Better Managed in Other Ways Coverage Not Needed


Insurance is NOT Gambling

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


Underwriting

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


Moral Hazard Simply Put, Ins Changes Behavior

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


Adverse Selection 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


The Insurance Mechanism Pooling of Similar Risks

Ex: 10,000 Toyota Camrys Using Historical Data, Losses Can Be

Predicted and Priced Appropriate Insurance Concepts

“Law of Large Numbers” “In the Long Run” “Diversified Portfolio”


Insurable Risks

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


The Insurance Mechanism Critical: Losses Cannot Be Correlated

Correlated Risks: EQ, Flood, Unemploy Ins Capital Required to Back Promises

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


Simplified Pricing Example

10,000 Toyota Camrys 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)


Other Pricing Considerations

Claims or Expenses May Come in High Owners Lose Money in “Bad” Periods Insurers May Purchase Reinsurance Insurer Receives Investment Income

Premiums Received Before Claims Paid Investment Holdings Regulated Investment Risks Can Affect Solvency


Rate Regulation

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.

State Guaranty Fund Assessments


Rate Regulation 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


Solvency Surveillance

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

Reserves Reflect Estimated Claim Costs


Solvency Surveillance:What Can Go Wrong?


Assets Liabilities

Cash 1,000,000 Unearned Premiums 500,000

Investments 9,000,000 Reserves 7,500,000

Surplus 2,000,000

Total 10,000,000 Total 10,000,000

Note: Insurance companies use different, more “stable” accounting rules called Statutory Accounting.

US Insurance Market

Very Large and Mature; Little Growth Divided into Two Main Sectors

Property/Casualty Insurance Life/Health (Includes Annuity Products)

Larger Organizations May Self Insure to Avoid Profit and Expense Loadings



Source: SNL Financial, Inc.

$502B

$576B

$175B

2011 U.S. Net Premiums Written

P&CLifeA&H

2011 P&C U.S. NPW by Line


2011 Life/A&H NPW by Line


The California Insurance Market

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


Policy Forms

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.


Policy Forms

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


Feel free to contact me:

David T. Russell, Ph.D.

California State University, Northridge

(818) 677-2438

[email protected]

INFORM+INSPIRE


Any Questions?

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INFORM+INSPIRE The Griffith Insurance Education Foundation Risk Management Principles and The Role of Insurance David T. Russell, Ph.D. Director, CSUN