Chapter Three

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```					Introduction to Risk
Management
Chapter 3 – Intro to Risk Mgmt.
Part I: Insurance Industry
Part II: Cost of Risk, Implications

University of Texas at Austin
Patricia M. Arnold, CPCU, ALCM
Intro to Risk Management
• Process (diagnosis)
• Evaluation (prognosis)
• Tools (treatment selection, application,
monitoring)

• See “outline”, “crossword”

Sep-09                                       2
Process
•   Objectives of the process
•   Analysis of potential losses
•   Choice: alternative risk treatment options
•   Implementation/monitoring

Sep-09                                                3
Process - objectives
• Preparedness
• Reduction of anxiety

• See “industry focus”

Sep-09                               4
Process – analysis step one:
identifying losses
•    Seven major areas
•    Sources of information

Sep-09                                    5
Process – analysis step two:
evaluating losses
•    Loss frequency
•    Loss severity
•    Maximum possible loss
•    Maximum probable loss

Sep-09                                     6
Process – recognizing Choices: selecting
treatment techniques
• Risk control
• Risk financing

Sep-09                                          7
Implementing the program
• Policy statement
• Collaboration between departments
• Periodic review and evaluation

Sep-09                                8
Key Ratios & Components
•   Expenses
•   Losses
•   Loss Ratio
•   Underwriting Ratio
•   Combined Ratio
•   Operating Ratio

Sep-09                               9
Sep-09   10
Income/ Outgo – the Dollar
- .35 (expenses to acquire & underwrite,
- .60 (loss costs)
\$0.05 to invest, grow surplus, improve
capacity
What if:
…you bring in a dollar and spend / pay out \$1.15?

Sep-09                                              11
ROE Decomposition

Sep-09                       12
Concepts & Ratios

Written

Combined
ratio

Sep-09                                  13
Operating Results Building Surplus
Increasing Capacity

Sep-09                                        14
P/C Net Income After Taxes
1991-2008 (\$ Millions)*
2001         ROE = -1.2%                                               Insurer profits peaked in 2006
2002         ROE = 2.2%

\$65,777
2003         ROE = 8.9%

\$61,940
2004         ROE = 9.4%
\$70,000
2005         ROE= 9.6%
2006         ROE = 12.2%
\$60,000

\$44,155
2007         ROAS1 = 12.3%**
2008         ROAS = 6.4%***

\$36,819

\$38,501
\$50,000

\$32,936
\$30,773

\$30,029
\$40,000
\$24,404

\$21,865
\$20,598

\$20,559
\$19,316

\$30,000
\$14,178

\$10,870

\$20,000
\$5,840

\$3,046
\$10,000
\$0
-\$10,000                                                                                                  -\$6,970
91
92
93
94
95
96
97
98
99
00
01
02
03
04
05
06
07
08*
*ROE figures are GAAP; 2008 figure is annualized Q1 net income of \$8.234B; 1Return on avg. surplus.
Sources: A.M. Best, ISO, Insurance Information Inst. ***9.5% excl. mortgage and finl. guarantee insurers.
ROE: P/C vs. All Industries 1987–2008:Q1
20%
Mortgage & Financial
P/C profitability is cyclical and                               Guarantee Impact
volatile

15%

10%
Sept. 11

5%

Hugo                                                                                                 Katrina,
Lowest CAT
losses in 15                                      Rita, Wilma
0%                                                                years
Andrew
Northridge                                             4 Hurricanes

-5%
87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08Q1
US P/C Insurers                         All US Industries
2008 P/C insurer figure is annualized Q1 return on average surplus. Excluding mortgage and financial guarantee insurers = 9.5%.
Source: ISO, Fortune; Insurance Information Institute.
Profitability Peaks & Troughs
in the P/C Insurance Industry, 1975 – 2008:Q1
25%
1977:19.0%                     1987:17.3%                   1997:11.6%           2006:12.2%

20%

15%

10%

5%                                                                                                2008Q1: 6.4%
(9.5% excl.
M&FG)
0%
1975: 2.4%               1984: 1.8%                  1992: 4.5%                  2001: -1.2%

-5%
75
76
77
78
79
80
81
82
83
84
85
86
87
88
89
90
91
92
93
94
95
96
97
98
99
00
01
02
03
04
05
06
07
08
*GAAP ROE for all years except 2007 which is ROAS of 12.3%. All figures include mortgage an d financial guarantee
insurers. Excluding M&FG insurers 2008:Q1 ROAS is 9.5%..
Source: Insurance Information Institute, ISO; Fortune
P/C Insurance Combined Ratio, 1970-2008F*
Combined Ratios
1970s: 100.3
1980s: 109.2
1990s: 107.8
2000s: 102.0*
120

115

110

105

100

95

90

08F
70
71
72
73
74
75
76
77
78
79
80
81
82
83
84
85
86
87
88
89
90
91
92
93
94
95
96
97
98
99
00
01
02
03
04
05
06
07
Sources: A.M. Best; ISO, III   *Full year 2008 estimates from III.
Underwriting Gain (Loss)
1975-2008:Q1*
35
30    Insurers earned a record underwriting profit of
25    \$31.7 billion in 2006, the largest ever but only
20   the second since 1978. Cumulative underwriting
15    deficit from 1975 through 2007 is \$422 billion.
10
5
\$ Billions

0
-5
-10
-15
-20                                                                                     \$561 mill
-25                                                                                    underwritin
-30                                                                                     g loss in
-35                                                                                    08:Q1 incl.
-40                                                                                    mort. & FG
-45                                                                                     insurers
-50
-55
75
76
77
78
79
80
81
82
83
84
85
86
87
88
89
90
91
92
93
94
95
96
97
98
99
00
01
02
03
04
05
06
07
08
Source: A.M. Best, ISO; Insurance Information Institute   * Includes mortgage * finl. guarantee insurers
Personal vs. Commercial Lines Underwriting
Expense Ratio*
32%                                    31.1%                                 Personal     Commercial

30%          29.4%             30.8%               30.0%
29.9%
29.1%
28%                                                                                      27.0% 27.5%
26.6%      25.6% 26.4%
26.3%
27.1%
26%                      25.0%                                     25.0%                26.6%
24.3%                                  24.8% 24.5%                 26.1%
25.6% 25.6%
23.4%                                                                 24.7%
24%
24.4% 24.6%

22%                Expenses ratios will likely rise as premium growth
slows

20%
96        97       98       99       00       01    02    03   04     05    06   07E   08F
*Ratio of expenses incurred to net premiums written.
Source: A.M. Best; Insurance Information Institute
Industry, 1999-2007E
\$ Billions
Ad spending by P/C insurers is at a record high,
\$4.5                signaling increased competition                                    \$4.323

\$4.0                                                                          \$3.695
\$3.5
\$2.975
\$3.0

\$2.5
\$2.111
\$1.882
\$2.0    \$1.736 \$1.737 \$1.803 \$1.708
\$1.5
99        00        01        02        03        04        05        06     07E
Source: Insurance Information Institute from consolidated P/C Annual Statement data.
P/C Insurance Industry Combined Ratio
2001-2010F            Including
As recently as 2001,                                             Mortgage &
insurers paid out nearly                                               Fin.
\$1.16 for every \$1 in                             Relatively      Guarantee
120          earned premiums                                  low CAT         insurers
115.8                                                    losses,
reserve
2005 ratio                            releases
benefited from                                          Cyclical
heavy use of                                         Deterioration
110                 reinsurance which
107.4    lowered net                                                  107
losses               Best
combined
ratio since             102.5   103
100.1           100.7    1949
100                            98.3           (87.6)         99.0

95.6
92.4

90
2001    2002    2003    2004    2005    2006   2007   2008   2008*   2009F   2010F
*Includes Mortgage & Financial Guarantee insurers.                  Sources: A.M. Best,
Strength of Recent Hard Markets
by NWP Growth
1975-78                1984-87                        2000-03
24%
22%
20%
denote “hard
18%                                                   market”
16%                                                   periods
14%
12%
10%                                                                      Negative or
zero growth
8%                                                                          likely
6%
4%
2%      In 2007 net written premiums fell
0.6%, the first decline since 1943
0%
-2%
1971
1972
1973
1974
1975
1976
1977
1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008F
2009F
2010F
Sources: A.M. Best, ISO, Insurance Information Institute
Property/Casualty Insurance Industry
Investment Gain1
\$ Billions
\$63.6
\$57.9                                                \$59.4
\$60                                                 \$56.9                                           \$55.7
\$52.3        \$51.9
\$47.2                                                        \$48.9
\$50                                                         \$44.4           \$45.3
\$42.8
\$40 \$35.4                                                           \$36.0

\$30

\$20                       Investment gains are off in 2008 due to
lower yields and poor equity market                                                     \$12.2
conditions.
\$10

\$0

1
*
94

95

96

97

98

99

00

01

02

03

04

06

07
05

Q
08
1Investment  gains consist primarily of interest, stock dividends and realized capital gains and losses.
2006 figure consists of \$52.3B net investment income and \$3.4B realized investment gain.
*2005 figure includes special one-time dividend of \$3.2B.
Sources: ISO; Insurance Information Institute.
U.S. Insured Catastrophe Losses*
\$ Billions
\$100 Billion
2008 CAT losses already exceed all of                                    CAT year is

\$100.0
2006/2007. 2005 was by far the worst                                    coming soon
\$120          year ever for insured catastrophe losses in
the US, but the worst has yet to come.
\$100

\$61.9
\$80
\$60

\$27.5
\$26.5
\$22.9

\$40
\$16.9

\$12.9
\$10.1

\$9.3
\$9.2
\$8.3

\$8.3
\$7.5

\$7.4

\$6.7
\$5.9
\$5.5
\$4.7

\$4.6
\$2.7

\$2.6
\$20
\$0
89
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91
92
93
94
95
96
97
98
99
00
01
02
03
04
05
06
07

20??
08:Q2**
*Excludes \$4B-\$6b offshore energy losses from Hurricanes Katrina & Rita.
**Based on preliminary PCS data through June 30.
Note: 2001 figure includes \$20.3B for 9/11 losses reported through 12/31/01. Includes only business and personal
property claims, business interruption and auto claims. Non-prop/BI losses = \$12.2B.
Source: Property Claims Service/ISO; Insurance Information Institute
Share of Losses Paid by Reinsurers, by
Disaster*
70%       Reinsurance is playing an
increasingly important                 60%
role in the financing of
60%              mega-CATs;
Reins. Costs are
50%              skyrocketing                                                           45%
40%
30%
30%                            25%
20%
20%

10%

0%
Hurricane Hugo Hurricane Andrew          Sept. 11 Terror 2004 Hurricane      2005 Hurricane
(1989)              (1992)          Attack (2001)      Losses               Losses
*Excludes losses paid by the Florida Hurricane Catastrophe Fund, a FL-only windstorm reinsurer,
which was established in 1994 after Hurricane Andrew. FHCF payments to insurers are estimated at
\$3.85 billion for 2004 and \$4.5 billion for 2005.
Sources: Wharton Risk Center, Disaster Insurance Project; Insurance Information Institute.
Reinsurer Market Share Comparison:
1990 vs. 2006
1990                                        2006

Offshore
Reinsurer            U.S.
35.3%             Reinsurer                    Offshore              U.S.
64.7%                       Reinsurer           Reinsurer
53.1%               46.9%

U.S. Reinsurer market
share fell precipitously
between 1990 and 2006

Sources: Reinsurance Association of America; Insurance Information Institute.
Personal, Commercial &
Self (Un) Insured Tort Costs*
\$250   Commercial Lines         Personal Lines      Self (Un)Insured
Total = \$216.7 Billion

\$200                                                                        \$45.5
Total = \$159.6 Billion
Billions

\$150                      Total = \$121.0 Billion     \$30.0
\$85.6
\$20.4
\$100                                                 \$70.9
Total = \$39.3 Billion    \$51.0
\$50
\$5.2                                                            \$85.6
\$17.1                \$49.6                \$58.7
\$17.0
\$0
1980                  1990                 2000                  2006
*Excludes medical malpractice
Source: Tillinghast-Towers Perrin, 2007 Update on US Tort Cost Trends.
U.S. Policyholder Surplus: 1975-2008:Q1*
\$550
Capacity as of 3/31/08 was \$515.6,
down 0.4% from 12/31/07
\$500                    …was \$517.9B, but 80% above its 2002 trough.
Recent peak was \$521.8 as of 9/30/07
\$450

\$400
\$0.85:\$1 at year-end 2007,
\$ Billions

\$350
approaching its record low of
\$0.84:\$1 in 1998
\$300

\$250

\$200

\$150

\$100                             “Surplus” is a measure of underwriting capacity.
It is analogous to “Owners Equity” or “Net Worth”
\$50                                    in non-insurance organizations
\$0
75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08

Source: A.M. Best, ISO, Insurance Information Institute.                  *As of March 31, 2008
Rating of Auto/Home Insurance Regulatory &
Operating Environment*
Most states (25) get a “B”, but 7 got
A’s, 10 got C’s (including DC), 5
AK
AL
earned D’s and 4 got F’s
WA                                                                                                                 ME

MT         ND                                                                           VT

MN                                                                NH

OR                                                                                                                  MA
NY
WI                                               CT
SD
=A                        ID                                                                MI                                          RI
=B                                   WY                                                                           P          NJ
IA                                          A
=C                                                                                                    OH                DC
NE                                                                           DE
=D                   NV                                                           IL       IN                                     MD
WV
=F                              UT                                                                                     VA
CO
KS                   MO                    KY
CA                                                                                                      NC
TN

OK                                                    SC
AZ         NM                                   AR

HI
2008.
MS                   GA

LA
TX

FL

*Criteria considered were auto/home residual mkts.,
auto/home mkt. concentration, loss ratio stability,
reg. env.,form regulation, credit scores, territorial
restrictions                                                            Source: James Madison Institute, Feb. 2008
Reason for P/C Insolvencies
(218 Insolvencies, 1993-2002)
Impaired Affiliate
3%                                          Deficient Loss
Unidentified                                                 Reserves
17%                                                          51%

Reserve
CAT Losses                                                    deficiencies
3%                                                         account for
more than half
Reinsurer Failure                                              of all p/c
0%                                                       insurers
insolvencies
3%                                                      So far, Katrina appears to
have claimed just 1
Discounted Ops
victim—Rosemont Re—
8%
expected to go into run-off
Overstated Assets
2%
Alleged Fraud     Rapid Growth
Sep-09                                                                             31
3%               10% Source: A.M. Best, Insurance Information Institute
Property and Liability Insurance

1. Fire insurance and allied      • Workers compensation
lines                          • Glass insurance
2. Marine insurance               • Boiler and machinery
–Ocean marine                 insurance
–Inland marine              • Nuclear insurance
• Crop-hail insurance
3. Casualty insurance
• Health insurance
–Automobile insurance
• Other miscellaneous lines
–General liability
4. Multiple-line insurance
insurance
–Burglary and theft      5. Fidelity and surety
insurance                  bonds
Sep-09                                                        32
Sep-09   33
All P/C Lines Distribution Channels,
Direct vs. Independent Agents
Direct     Independent Agents
70%

60%

50%

40%

30%                           Independent agents steadily lost market share from the
early 1980s through the early 2000s across all P/C lines,
but have gained in recent years. Direct channels include
20%                           exclusive agency companies, direct marketers and direct
sales (e.g., internet)

10%

0%
83
84
85
86
87
88
89
90
91
92
93
94
95
96
97
98
99
00
01
02
03
04
05
06
Source: Insurance Information Institute; based on data from Conning and A.M. Best.
U.S. Domiciled Captives- Net
\$10.5    Following a five-year period of rapid
growth, U.S. captive insurers saw net                         \$10.2
premiums written increase by just 2.7
percent in 2006, after 6.2 percent
\$10.0              growth in 2005.                          \$9.9
\$ Millions

\$9.5                                     \$9.3

\$9.0
\$9.0

\$8.5    \$8.4

\$8.0
2002           2003              2004              2005      2006
Source: A.M. Best, 2007 Special Report: U.S. Captive Insurers – 2006 Market Review
Resources for review

• Loss Control and Risk Management sites
– Institute for Business and Home Safety
– Risk Management Checklist (pdf) (courtesy of The Associated
General Contractors (AGC) of America)

See “industry focus”
Sep-09                                                           36
Part II
• Cost of Risk
• Implications

Sep-09                     37
Insurance is the Biggest Concern of Small
Labor Qlty. Labor Costs Inflation
Competition              10%         5%          2%
7%                                           Credit/Int.
Rates
Regulations                                                 2%
9%

Poor Sales                                                           Insurance
18%                                                                   28%

Taxes
17%
Sep-09                                                                               38
Source: National Federation of Independent Business (June 2003); Insurance Information Institute
Cost of Risk: 1990-2004*
\$16

\$13.91
\$14                                                                                                         \$13.50

\$11.95
\$12

\$10
\$8.30                                                                 \$8.42
\$7.70
\$8                                    \$7.30
\$6.49
\$6.10 \$6.40
\$5.70           \$5.71
\$6                                                            \$5.25
\$5.20 \$4.83

\$4
90     91     92      93      94      95      96      97      98      99   00       01     02      03    04

* Cost of risk includes insurance premiums, retained losses and administrative expenses
Sep-09                                                                                                       39
Source: 2004 RIMS Benchmark Survey; Insurance Information Institute
Tort Cost Growth & Medical Cost Inflation vs.
Overall Inflation (CPI-U), 1961-2008*
Tort costs move with inflation but at               Tort System is an Inflation
14%                     twice the rate                                    Amplifier
Avg. Ann. Change: 1961-2008*
Torts Costs: +8.4%
12%                                                                  Med Costs: +6.0%
Overall Inflation: +4.2%
10%
8%
6%
4%
2%
Tort Costs       Medical Costs        CPI
0%
1961-70          1971-80           1981-90         1991-2000         2001-08E
*Medical cost and CPI-U through April 2008 from BLS. Tort figure is for full-year 2008
from Tillinghast.
Sources: US Bureau of Labor Statistics, Tillinghast-Towers Perrin, 2007 Update on U.S. Tort Costs; In
Consumer Price Index for Medical Care
vs. All Items, 1960-2007
(Base: 1982-84=100)

400   Soaring medical inflation
is among the most        Inflation for Medical Care has
serious long-term       been surging ahead of general
351.1
challenges facing        inflation (CPI) for 25 years.
casualty, disability and
Index Value (1982-84=100)

300          LTC insurers          Since 1982-84, the cost of
medical care has more than
tripled
207.3
200

100

All Items     Medical Care
0
60
61
62
63
64
65
66
67
68
69
70
71
72
73
74
75
76
77
78
79
80
81
82
83
84
85
86
87
88
89
90
91
92
93
94
95
96
97
98
99
00
01
02
03
04
05
06
07
Source: Department of Labor (Bureau of Labor Statistics; Insurance Information Institute.
Retention program:
The following advantages may result from a risk retention
program
• The corporation can save money if its actual losses are
less than the loss allowance in the insurer's premium.
• There may also be sizable expense savings.
• Loss prevention is encouraged.
• Cash flow may be increased, since the firm can use the
funds that normally would be held by the insurer.

Sep-09                                                         42
How the Risk Dollar is Spent (2004)
Total liability costs account for about 40% of the risk dollar
Firms w/Revenues < \$1 Billion Firms w/Revenues > \$1 Billion
Property
Retained     9%                                                           Liability
Liability                                                                  14%                          7%
3%                                                         Liability
14%                                                  Property
Liability                                                    Property                                                            19%
27%

16%                                                                 Property
6%
Total Prof. Liab
Total Mgmt.                         Retained WC                                         WC Premiums
Retained WC                                     4%
Other      Liab.                                24%                   Total Mgmt.   Total Prof. Liab 6%
6%                                                                         Other
1%         8%                                                           Liab.           5%
1%
6%
Sep-09                                                                                                                     43
Source: RIMS (2004); Insurance Information Institute
Construction Defect Problem

• Growing number of lawsuits target:
– Builders, Contractors, Developers, Sub-Contractors, Material
Suppliers, Product Manufacturers, Architects & Engineers.
• Construction defect claims include:
– Subsidence, collapse, cracks in walls & foundations.
– Leaking roofs, windows, doors, foundations.
– Dry rot of wood or other building materials, pest infestations.
– Mold, code violations, improper specification of building materials.
• Hotspots:
York.

Sep-09                                                                  44
U.S.: Documented Toxic Mold Suits
Former
Owners of
10%                           Against
Insurers
1,000
Cases
50%
Builder for
Construction
2,000                5,000
Defects
Cases                Cases
20%
2,000
Cases
HO
Associations
for Improper
Maintenance
Sep-09                                                             45
20%                        Source: www.toxlaw.com; Guy Carpenter

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