Risk and its Treatments

Chapter 1: Risk and its Treatments ● ● Risk: The fear concerning the occurrence of a loss Difference between Risk and Uncertainty: ○ Risk: The probability of the occurrence of a loss can be estimated with some accuracy ○ Uncertainty: Such probability cannot be estimated (sometimes a subjective guess exists) Risk managers often use the term “loss exposure” to describe potential losses: ○ Loss Exposure: Any situation or circumstance in which a loss is possible, regardless of whether a loss occurs Classification of Risk ● ● ● ● Pure Risk: There are only the possibilities of loss or no loss (earthquake, car accident) - [can be insured] Speculative Risk: Both profit or loss are possible (Gambling, stock exchange) Diversifiable Risk: Affects only individuals or small groups (car theft) It is also called nonsystematic risk or particular risk Nondiversifiable Risk: affects the entire economy or large numbers of persons or groups within the economy (hurricane). Also called systematic risk  or fundamental risk ■ Gov. assistance may be necessary to insure nondiversifiable risks Objective and Subjectivity Probability of a Loss ● Probability of loss: The probability that an event that causes a loss will occur ○ Objective Probability: Refers to the long-run relative frequency of an event based on the assumptions of an infinite number of observations with no change in the underlying conditions (is the same for different individuals) ■ Objective probabilities can be determined… 1. A priori: By logical deduction  such as games of chance 2. Empirically: By induction, through analysis of data ● Subjective Probability: is an individual’s personal estimate of the chance of loss (varies between individuals) Objective Risk: the relative variation of actual loss from expected loss ● Can be measured by parameters that characterize the probability of destruction ○ Variance ○ Standard Deviation ○ Coefficient of variation ● A probability distribution is characterized by: ○ A mean (expected value), or measure of central tendency ○ A variance, or measure of dispersion How to Measure Risk John’s Case ● John is a reasonable person. He received an inheritance of $10,000 from an uncle. Now he is unsure of what to do with the money for investment purposes ○ His options: ■ 1. Store the money in a safe ● Payoff: $10,000 ● Probability: 1 ■ 2. Invest in a bond with 7% interest p.a. (Risk Averse person would choose this option) ● Payoff: $10,700 ● Probability: 1 ■ 3. Toss-a-coin Mutual fund ● Coin is tossed, if heads: he earns investment income of $3,000 ● If tails, he loses $1,500 of the principal ● Payoff: => $13,000 or $8500 ● Probability: 0.5 or 0.5 ○ Majority would choose to go with the bond Expected Value or Mean Risky decisions and Expected Value ● ● ● ● ● Expected Value evaluations only consider expected return of a lottery They do not account for the fact whether a lottery is risky or not Consider the two lotteries: Losing 1$ with 90% probability to losing 10,000$ with.009% probability Which one would you prefer? Expected value theory is indifferent between these two lotteries! Another definition of Risk Risk: The possibility of a (positive or negative) deviation from the expected outcome (ambiguous risk definition) Measuring Volatility ● ● ● The variance are the squared differences to Expected Value multiplied with their probability The standard deviation is the square root of the variance The standard deviation is a measure for risk ○ it measures the average deviation from the mean ○ Higher standard deviations are associated with greater uncertainty of loss; therefore the risk is greater! Another example of a probability distribution: ● Scheme for easy calculation of the mean: Variance and standard deviation ● Variance is this probability distribution: ● ● ● The standard deviation is the square root of the variance The standard deviation is measured in the same units as the data ● ● The standard deviation = Higher standard deviations, relative to the mean, are associated with greater uncertainty of loss...therefore, the risk is greater! Risk attitudes/ Risk Neutrality ● ● An individual is assumed to be risk neutral if she is indifferent between any two lotteries with the same expected outcome (Expected Value) Choosing the outcome with the highest expected return is the optimal strategy for a risk neutral individual (using expected value theory) ● Risk-averse People - if he or she prefers to receive the Expected Value of a lottery for certain rather than owning the risky lottery ○ Choosing the outcome with the highest expected return, ex: using expected value theory, may not always be appropriate as it ignores the riskiness of a lottery! ■ A risk averse person prefers receiving 10,750$ to the lottery option three of john ■ A risk averse person prefers paying 90 cents to losing 10,000 with probability of .009% Why do people take out insurance? – Because they are Risk-averse ● Remember: a person is risk averse if he or she prefers a certain amount of wealth to a risky situation that yields the same expected wealth ○ This implies that given complete info about the risk, a risk averse person prefers full insurance over the uninsured situation if the insurance premium equals expected losses ● The person would even be willing to accept a premium loading (in addition to the expected losses), the maximum “tolerable” loading depending on the degree of risk aversion The “Insurance Vocabulary” ● ● ● Peril: cause of the loss (in a car accident, the collision is the peril) Hazard: condition that increases the chance of loss or the severity of loss ○ Physical hazard: physical condition that increases the frequency or severity of loss (such as: icy streets, poorly designed intersections, dimly lit stairways, etc.) ○ Legal hazard: characteristics of the legal system or regulatory environment that increase the frequency or severity of loss ○ Moral hazard: dishonesty or characteristics of an individual that increase the chance or frequency of a loss ○ *Morale hazard: carelessness or indifference to a loss because of the existence of insurance But: recent theory of insurance usually defines moral hazard as: ○ insurance-induced changes of an insured’s behavior in the presence of asymmetric information ○ Moral hazard is NOT insurance fraud (= criminal intent!) Insurance Fraud is a crime ● Types of Insurance Fraud with typically high loss amount: ● willful causation of loss ● fake of insured loss ● types of insurance fraud with typically low loss amount ● overstatement of size ● redefinition Types of Risk ● Enterprise Risk encompasses all major risks faced by a business firm: ● Strategic Risk refers to uncertainty regarding the firm’s financial goals ● Operational Risk results from the firm’s business operations ● Financial Risk refers to the uncertainty of loss because of adverse changes in commodity prices, interest rates, foreign exchange rates, and the value of money ● Enterprise Risk Management (ERM): combines into single unified treatment program all major risks faced by the firm Personal Risks ● ● Personal risk: risks that directly affect an individual or family They involve the possibility of a loss or reduction in income, extra expenses or depletion of financial assets, due to: ○ Premature death of family head ○ Insufficient income during retirement ○ Poor health (catastrophic medical bills and loss of earned income) ○ Involuntary unemployment Commercial Risks ● ● ● ● Commercial Risk: risks faced by a business firm, including property, liability, and other risks. Property Risks: involve the possibility of losses associated with the destruction or theft of property Direct loss vs. indirect loss ○ A Direct Loss is a financial loss resulting from the physical damage, destruction, or theft of the property (i.e. fire damage to a home) ○ An Indirect Loss is a financial loss resulting indirectly from the occurrence of a direct damage or(i.e. the additional living expenses after a fire) Liability risks: risks resulting from the possibility that you are being held legally liable for bodily injury, or property damage to someone else ○ There is no maximum upper limit with respect to the amount of the loss ○ A lien can be placed on your income and financial assets (Lien: a right to keep possession of property belonging to another person until a debt owed by that person is discharged) ● ○ Legal defense costs can be enormous Example: For each of the following, identify the type of risk that is present and explain your answer. ○ ○ ○ ○ ○ ○ a) The Department of Homeland Security alerts the nation of a possible terrorist attack. ■ Non-Diversifiable risk b) Your house may be severely damaged in a fire. ■ Personal risk, Pure risk c) A family head may be totally disabled in a plant explosion. ■ ? d) An investor buys 100 shares of Microsoft. ■ Diversifiable risk,Financial risk, Speculative risk e) A river that periodically overflows may cause substantial property damage to thousands of homes in the floodplain. ■ Non-Diversifiable risk, Personal risk, Pure risk f) Home buyers may be faced with higher mortgage payments if the Federal Reserve raises interest rates. ■ ○ Non-Diversifiable risk (b/c everyone can be a home buyer), Pure risk (in this situation), Financial risk g) A worker on vacation plays the slot machines in a casino. ■ Speculative risk, Personal risk, Financial risk Why does risk matter? ● Risk has several effects on society: ○ Reserves and Emergency Funds must be set aside for “rainy days” ○ Discontinuation of goods and services occur because of the risk of loss (Example: some companies will not operate in the U.S. for fear of lawsuits) ○ Risk can introduce worry and fear into our lives SUMMARY OF CHAPTER 1: ● Risk has no single definition. It can be subjective or objective, pure or speculative ○ Risk can be defined as the possibility of a (positive or negative) deviation from the expected outcome ● Risk aversion means an individual prefers a certain amount of wealth to a risky situation that yields the same expected wealth ○ Risk aversion is the major motive for insurance demand ● Enterprise Risk Management (ERM) combines into a single unified treatment program all major risk a firm faces: ○ strategic risks, operational risks, and financial risks are all considered together to lower the firm’s overall risk! Chapter 2: Insurance and Risk Pooling ● Insurance: “Insurance is the pooling of fortuitous losses by transfer of such risks to insurers, who agree to indemnify for such losses, to provide other pecuniary benefits on their occurrence, or to render services connected with the risk.” Basic Characteristics of an Insurance Arrangement: Payment of fortuitous losses A fortuitous loss is one that is unforeseen, unexpected, and occurs as a random result of chance Risk transfer A pure risk is transferred from the insured to the insurer, who typically is in a stronger financial position Indemnification Indemnification The insured is restored to his or her approximate financial position prior to the occurrence of the loss Pooling of Risks Pooling is the spreading of losses incurred by the few over the entire group, so that in the process, average loss is substituted for actual loss ● ● ● ● ● ● ● ● ● Example: Samantha and Emily both face the risk of losing 2,500 $ with 20% chance (assume the events are independent, i.e., uncorrelated) Expected costs of the risk for each: 2,500 · 0.2 = 500 $ Standard Deviation: \ This is the answer to ○ How much does the outcome differ from the mean on average? Samantha and Emily could enter an agreement to equally share losses: What happens to each person’s expected loss, standard deviation of loss, and maximum probable loss? Let’s calculate expected loss, standard deviation, and PML for the shared loss distribution Maximum Probable Loss: 2,500 No reduction in Expected Loss and Maximum Probable Loss, but the standard deviation is reduced from 1,000 to 707 Risk pooling ● ● ● ● Additional risk reduction can be obtained by adding further individuals into the pooling agreement. First mutual insurance agreements evolved from this idea. Insurance companies manage risk pools and can therefore work with a reduced volatility. Insurance companies cannot share losses ex-post and therefore usually charge an insurance premium ex-ante to cover the potential losses. ● Correlations may play an important role! Law of Large Numbers ● ● Note that the Law of Large Numbers only applies to i.i.d. random variables In words: If the number of risks in the portfolio tends to infinity, the probability that the average outcome differs from expected value is positive tends to zero. The Central Limit Theorem ● German mathematician and astronomer Carl Friedrich Gauss Implications of the Central Limit Theory for Insurers: ● Average losses for a (large) random sample of n exposure units will follow a normal distribution 1. The distribution of sample means does not depend on the population distribution (Dice Experiment) 1. The distribution of sample means does not depend on the population distribution! 2. The standard error of the sample mean distribution declines as the sample size increases. Sampling Distribution vs Sample Size 3. The standard error of the sample mean distribution declines as the sample size increases. Distribution versus Sample Size ● But...the Law of Large Numbers and the Central Limit Theorem only hold if random variables are stochastically independent ● Would you assume stochastically independence in ○ Insurance portfolios? ○ Stock markets? Pooling with correlated losses ● Positive correlation vs. perfect correlation ● Remember Samantha and Emily? Effect of Positive Correlation on Risk Reduction: Pooling with correlated losses ● Pooling arrangements cannot reduce volatility if perfectly positively correlated ● Positive correlation leads to a reduction of standard deviation yet lower than without correlation ● Positive correlation is very common in insurance, stock or other markets, yet perfect correlation is rare Characteristics of insurable risks The six characteristics of an (ideally) insurable risk 1. Large number of exposure units Is necessary to predict the average loss based on the law of large numbers 2. Accidental and unintentional loss Because the law of large numbers is based on the random occurrence of events 3. Determinable and measurable loss ● ● Determinable: the loss should be definite as to cause, time, place and size Measurable: to determine how much should be paid 4. No catastrophic loss / limited loss size To allow the pooling technique to work ● Exposures to catastrophic loss can be managed by using reinsurance, dispersing coverage over a large geographic area, or using financial instruments, such as catastrophe bonds 5. Calculable probability of loss To establish a premium that is sufficient to pay all claims and expenses and yields a profit during the policy period 6. Economically feasible premium So people can afford to purchase the policy ● For insurance to be an attractive purchase, the premiums paid must be substantially less than the face value, or amount, of the policy ● Based on these requirements: ○ Most personal, property and liability risks can be insured ○ Market risks, financial risks, production risks and political risks are generally difficult to insure ● Is auto damage insurable? • Large # of Exposure Units ✔ • Loss Accidental and Unintentional ✔ • Loss Determinable and Measurable ✔ • Loss Not Catastrophic ✔ • Chance of Loss Calculable ✔ • Premium Economically Feasible ✔ ● Is war insurable? • Large # of Exposure Units ㄨ  • Loss Accidental and Unintentional ㄨ  • Loss Determinable and Measurable ㄨ  • Loss Not Catastrophic ㄨ  • Chance of Loss Calculable ㄨ  • Premium Economically Feasible ㄨ  Adverse Selection and Insurance ● Adverse Selection: The tendency of persons with a higher-than-average chance of loss (Ex: “bad risks”) to seek insurance at standard rates ● Adverse selection can be controlled by: ○ Careful Underwriting (selection and classification of applicants for insurance) ■ If not controlled by underwriting, adverse selection results in higher-than-expected loss levels ○ Policy Provisions (Example: suicide clause in life insurance) ○ Coinsurance (a type of insurance in which the insured pays a share of the payment made against a claim) Insurability Problems Adverse selection ● Insurance coverage is more attractive to individuals with a higher risk exposure ● If risk exposure is not observable by the insurance companies (hidden characteristics), adverse selection threatens ● Higher risk exposure individuals may drive lower risk exposure individuals out off the market ● Market failure may happen Moral hazard ● Moral hazard describes insurance-induced behavioral changes of insureds which affect the overall outcome ● Insureds may be less precarious or utilize insured services up to a higher level than without insurance ● Insurance prices have to be increased in order to account for higher costs ● Cannot always be completely prevented ● Moral hazard issues can be addressed by product design (deductibles, coinsurance, etc..) Risks should be quantifiable ● ● ● Problems of adequately estimating and quantifying the risk are often named a reason for (individual) lack of insurability (e.g. terrorist attacks). However: many decisions are based on “subjective” probabilities to some extent as definite probabilities are usually not available. Accordingly, boundaries of insurability concerning this criterion are usually rather subjective and somewhat fuzzy. Correlation and total exposure ● ● Typical problem in some lines of business: dependencies such as accumulation risk and/or the risk of „infections“. Extreme loss potential possible due to accumulation (Ex: losses caused by windstorm) or very high individual losses possible (Ex: liability insurance for nuclear power plants). SUMMARY of Chapter 2 ● ● Insurers use risk pooling based on the Law of Large Numbers ○ Pooling means average loss is substituted for actual loss ○ This enables the policyholders to replace uncertain losses with a certain payment (the premium) ○ Risk averse individuals would always want to insure themselves at a fair premium (no loading) Adverse selection and moral hazard may cause failure of insurance markets ○ If not controlled by underwriting, adverse selection and moral hazard may result in higher-than-expected loss levels Chapters 3-4: Introduction to Risk Management and Insurance ● Risk management: A scientific approach to handling risks by anticipating possible losses and designing and implementing procedures that minimize the occurrence of loss or the financial impact of the losses that do occur ● a process which attempts to minimize the cost of loss Objectives of Risk Management ● ● ● Risk management has objectives before and after a loss occurs Pre-loss objectives: - Prepare for potential losses in the most economical way - Reduction of anxiety - continue operating Post-loss objectives (in order or importance) - Survival of the firm - Continue operating - Stability of earnings - Continued growth of the firm - Social responsibility Risk Management Process (4 Steps) 1. Identity 2. Evaluate 3. Select a Technique - Avoid - Retain - Transfer (Insurance or Other Contractual) - Control 4. Implement and Monitor Step 1: Identify loss Exposures ● Property loss exposures ● buildings, plants, structures ● computers, software, data ● furniture and equipment ● Liability Loss Exposures ● defective products ● environmental pollution ● discrimination, failure to promote ● Business Income Loss Exposures ● loss of income from a covered loss ● continuing expenses after a loss ● Risk managers have several sources of information to identify risks ○ risk analysis questionnaires, and checklists ○ financial statements ○ losses in past years ○ historical loss data ○ physical inspection ● Industry trends and Market changes can create new loss exposures (Example: exposure to acts of terrorism) ● Strategy Analysis: Involves planning and (sometimes short) term goals for an organization ● A SWOT analysis examines an organization's: ○ Strengths (Internal) ○ Weaknesses (Internal.) ○ Opportunities (external.) ○ Threats (external.) ● Which will affect its ability to meet strategic goals? Step 2: Evaluate loss exposures ● Estimate for each type of loss exposure ○ Loss Frequency: probable number of losses that may occur during some time period ○ Loss Severity: the probable size of the losses may occur ● Rank exposures by importance ● Loss severity is more important than loss frequency: ○ Maximum Possible Loss: worst loss that could happen to a firm during its lifetime ○ Probable Maximum Loss: the worst loss that is likely to happen Step 3: Select a Technique ● ● ● Risk ○ Risk Control Techniques reduce the frequency and severity of losses Methods of Risk Control: ○ Avoidance (not always possible): means a certain loss exposure is never acquired or undertaken, or an existing loss exposure is abandoned ■ The chance of loss is reduced to zero ■ It is not always possible, or practical, to avoid all losses ■ Avoidance is the appropriate technique for treating high frequency-high severity loss exposures ○ Loss Prevention: Measures that reduce the frequency of a particular loss ■ Example: installing safety features on hazardous products, burglar alarm in houses, etc. ○ Loss Reduction: methods that refer to techniques that provide for the payment of losses after they occur ■ Example: Installing an automatic sprinkler system Financing: techniques that provide for the payment of losses after they occur Methods: Retention, Transfer, Insurance Retention: The firm retains part or all of the losses that can result from a given loss ● Effectively used when: ○ No other method of treatment is available ○ The worst possible loss is not serious ○ Losses are highly predictable ● Retention Level: The dollar amount of losses that the firm will retain ● Captive insurer is an insurer owned by a parent firm for the purpose of insuring the parent firmʼs loss exposures ○ A single-parent captive is owned by only one parent ○ An association or group captive is an insurer owned by several parents ○ Reasons for forming a captive include: ■ The parent firm may have difficulty obtaining insurance ■ To take advantage of a favorable regulatory environment ■ Costs may be lower than purchasing commercial insurance ■ A captive insurer has easier access to a reinsurer ■ A captive insurer can become a source of profit ● Self-insurance, or Self-funding: a special form of planned retention by which part or all of a given loss exposure is retained by the firm ○ Risk retention group (RRG): a group captive that can write any type of liability coverage except employers’ liability, workers compensation, and personal lines ■ Exempt from many state insurance laws Advantages: ● Save on loss costs ● Save on expenses ● Encourage loss prevention ● Increase cash flow Disadvantages: ● ● ● Possible higher losses Possible higher expenses Possible higher taxes Non-Insurance Transfer: a method other than insurance by which a pure risk and its potential financial consequences are transferred to another party ● Examples: contracts, leases, hold-harmless agreements Advantages: ● Can transfer some losses that are not insurable ● Less expensive ● Can transfer loss to someone who is in a better position to control losses Disadvantages: ● ● ● Contract language may be ambiguous, so transfer may fail If the other party fails to pay, firm is still responsible for the loss Insurers may not give credit for transfers Insurance: appropriate for low-probability, high-severity loss exposures ● ● ● ● The risk manager selects the coverages needed, and policy provisions A deductible is a specified amount subtracted from the loss payment otherwise payable to the insured In an excess insurance policy, the insurer pays only if the actual loss exceeds the amount a firm has decided to retain The risk manager selects the insurer, or insurers, to provide the coverages Advantages: ● Firm is indemnified for losses ● Uncertainty is reduced ● Insurers can provide valuable risk management services ● Premiums are income-tax deductible Disadvantages: ● ● ● Premiums may be costly Negotiation of contracts takes time and effort The risk manager may become lax in exercising loss control Step 4: Implement and Monitor the Risk Management Program ● Implementation of a risk management program begins with a Risk Management Policy Statement: ○ Outlines the firmʼs objectives and policies ○ Educates top-level executives ○ Gives the risk manager greater authority ○ Provides standards for judging the risk managerʼs performance ● ■ The risk management program should be periodically reviewed Risk Management Manual: may be used to: Describe the risk management program and train new employees SUMMARY of Chapter 3-4 ● Risk Management is beneficial to both firms and society ○ It enables the firm to attain its pre-loss and post-loss objectives more easily ○ Risk Management Techniques include: ■ avoid, retain, transfer (insurance, other) and control ● A risk management program can reduce a firmʼs cost of risk ● Society benefits because both direct and indirect losses are reduced