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Principles of Risk Management and Insurance

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					    Risk Management




Hurricane Katrina: Landfall August 29,   1
                2005
       Fair Bet

• Cost Equals Expected Gain
• Cost = P * (Amount you Win)
• Example: Flipping a Coin
    – Cost = $10
    – P = .5
    – Amount You Win = $20


                                2
     Is This A Fair Bet?
• Flipping A Coin
  – Cost = $50
  – Amount You Win = $75




                           3
  Risk Taking Behavior

• Risk-Averse
• Risk-Neutral
• Risk-Taker (Risk-Seeker, Risk-Lover)




                                    4
    Risk and Uncertainty

• Risk: A situation in which
  several different
  outcomes are possible.
• Uncertainty: The
  perception that several
  different outcomes are
  possible.
                               5
      Categorizing Risk


• Pure Risk v. Speculative Risk
• Diversifiable Risk v. Nondiversifiable Risk
• Fundamental Risks and Particular Risks




                                                6
 Pure Risks v. Speculative Risks

• Speculative Risks are Usually Chosen
   – Stock Appreciation
   – Manufacturing and Selling a Product
   – Example: Furby


• Pure Risks are Usually a Byproduct
   – Automobile Accident
   – Sports Injury

                                           7
      Diversification
• Pooling Similar Risks
  – INSURANCE
• Pooling Offsetting Risks
  – A DIVERSIFIED PORTFOLIO




                              8
Why Reduce Uncertainty


    • Individual
    • Corporations
    • Government



                         9
             Why Manage Risk?
                Individuals
• Reduce anxiety




• Planning




                                10
Why Manage Risks:
   Corporation
  (Nexus of Contracts)




                         11
Early Historical Examples
  of Risk Management



    • Chinese Trading Boats

    • Amish Rebuilding



                              12
Modern Risk Management

• Prior to 1950s: Insurance Purchaser
• Risk Managers
  – Finance Dept., Freestanding, or
    Human Resource Dept.
  – Larger Companies
  – Companies Facing Greater Risk

                                      13
           Risk Manager:
Minimize Adverse Consequences of Risk


      •   Avoidance
      •   Loss Control
      •   Self-Insurance
      •   Purchase Insurance
      •   Anticipate Risk

                                   14
  The Decision to
Manufacture a Product




                        15
Product Development:
     Motorcycle

   • Investment: $1,000,000
   • Profits if there is no Loss:
     $150,000
   • Possible Liability Losses:
     – 1% Chance of $2,000,000
       Loss
   • Required Return on
     Investment: 10%
                                    16
Hiring an Employee




                     17
Hiring an Employee: Baseball
 Player with Drug Addiction

    • Salary: $200,000/year
    • Financial Contribution to Club
      – $300,000 if Says Clean
      – $50,000 if Uses Drugs
      – Chance of Staying Clean: 50%



                                 18
Major Duties of Risk Managers

  •   Buy Insurance
  •   Identify Risk
  •   Loss Prevention and Loss Control
  •   Contract Review
  •   Safety Training and Education
  •   Govt. Compliance with Safety Issues
  •   Risk Finance
  •   Claims Mgmt. and Litigation Support
  •   Employee Benefits                     19
Risk Management Process

 •   Mission Identification
 •   Risk Identification
 •   Risk Analysis
 •   Consider Alternatives
     – Risk Control
     – Risk Finance
 • Implement and Monitor      20
Mission Identification



• Goal of Organization

• Goal of Risk
  Management Department

                          21
        Organization Goals
• Corporation: Maximize Profits
• Non-Profit Organizations
  – Religious Organization
  – Hospitals




                                  22
      Organization Goals

• Charities
  – Red Cross: The
   American Red Cross, a
   humanitarian organization
   led by volunteers, . . . will
   provide relief to victims of
   disasters and help people
   prevent, prepare for, and
   respond to emergencies.



                                   23
Post-Loss Objectives

  •   Survival of the Organization
  •   Continuity of Operations
  •   Earnings Stability
  •   Continued Growth
  •   Social Responsibility
                                     24
Pre-Loss Objectives

• Economy
• Reduction in Anxiety
  –   Owners
  –   Suppliers
  –   Lenders
  –   Customers
  –   Govt. Agencies
• Meeting Externally Imposed Obligations
• Social Responsibility
                                      25
Risk Management Process
         Step 2



Risk Identification and Analysis




                                   26
Risk Identification: Key Terms


         •   Hazard
         •   Risk Factor
         •   Peril
         •   Exposure



                                 27
             Difficulties with
            Risk Identification

• New Laws
  – Examples: Building Codes, Clean Air Act

• New Discoveries
  – Examples: Black Lung, Second Hand Smoke

• Changing Societal Attitudes
  – Example: Product Liability Laws, Cigarettes


                                                  28
 New Laws and
Risk Identification




                      29
    Sources of Risk

•   Physical Environment
•   Social Environment
•   Political Environment
•   Legal Environment
•   Operational Environment
•   Economic Environment
•   Cognitive Environment
                              30
           Social Environment
            and Disney Co.
•   Euro-Disney
•   “Powder”
•   Domestic Partner Benefits
•   History Theme Park at Manassas




                                     31
               Example
• Workplace Injury




                         32
Categories of Exposures

 • Property Exposures
   – Direct: Immediate Result
   – Indirect: Secondary Results
   – Example: Robbery of a Store
 • Liability Exposures
 • Human Resource Exposures


                                   33
Risk Identification Methods 1

   •   Insurance Survey
   •   Risk Analysis Questionnaires
   •   Financial Statement Analysis
   •   Flow Chart Method
   •   Systems Safety Techniques


                                      34
Risk Identification Methods 2


•   Interactions with External Resources
•   Interactions with other Departments
•   Past Losses
•   On-Site Inspections



                                       35
Accident Causation


 • Human Relations View

 • Engineering View


                          36
    Loss Analysis Ratios


• Severity = $Losses / # Losses

• Frequency = # Losses / # Exposures

• Expected Loss = $ Losses/ # Exposures

                                       37
            Ratios Example

• Data
   – 1000 Restaurants
   – 50 Fires
      • Type 1 Fires: 20, $25,000
      • Type 2 Fires: 30, $50,000


• Severity = [20($25,000) + 30($50,000)]/50 = $40,000
• Frequency = 50 / 1000 = .05
• Expected Loss = .05($40,000) = $2000

                                                  38
    Concerns with
  Measuring Severity


• Indirect Losses
  – Ex: Store robbery
• Contagion
  – Ex: Foot-and-Mouth Disease
• Snowball Effect
  – Ex: Mad Cow Disease

                                 39
Contagion Example: Bil Mar




                             40
         Contagion Example: Listeria
• Chicago-based Sara Lee recalled hot dogs and deli meats
  produced at its Bil Mar plant in Zeeland, Michigan, after the
  CDC found listeria contamination in unopened packages of
  the products.

• Affected brand names include Ball Park, Bil Mar, Sara Lee
  Deli Meat and Sara Lee Home Roast.

• The states reporting listeria infections are Arizona,
  Connecticut, Georgia, Indiana, Iowa, Kentucky, Maryland,
  Massachusetts, Michigan, Minnesota, New York, Ohio,
  Oregon, Pennsylvania, Tennessee, Vermont and West
  Virginia.

                                                                  41
Contagion Example: Listeria


• Tainted meat
  – Killed 12 people
  – Sickened 79 others in 16 states


• 241 workers fired or layed off


                                      42
Loss Severity Measures




 • Maximum Possible Loss

 • Maximum Probable Loss


                           43
Example




          44
Loss Statistics




                  45
Loss Statistics




                  46
    Normal Distn Severity

Distance   Prob
1 S.D.     68.2%
2 S.D.     95%




                              $218,750
                   $191,959              $245,541
     $165,168                                       $272,332

[    freq = .00064
[    sev = $272,332
[    E(L)95% = $174.29
                                                               47
 Calculating the Mean and Std. Dev.




mean =   .10(0)+.20(10)+.40(30)+.20(50)+.10(60) = 30

S.D. =   sq. root [.10(0-30)(0-30) +.20(10-30)(10-30) +.40(30-30)(30-30)
         +.20(50-30)(50-30) +.10(60-30)(60-30)] = 18.43
                                                                           48
Important Distributions


  • Loss Frequency Distribution

  • Loss Severity Distribution

  • Total Loss Distribution


                                  49
Loss Frequency Distn
    Taxi Accidents N = 2000




 .015(2000) = 30 Accidents
                              50
Loss Severity Distn
       N = 100




                      51
 Drawbacks to Use
 of Historical Data



• CHANGE in Process

• Insufficient Data



                      52
Importance of Timing
     of Losses



• Time Value of Money

• Cash Flow Considerations



                             53
      Loss Triangles


• Predict When Losses Will Occur

• Predict Total Losses

• Highlight Trends

                                   54
                       Loss Triangle
                 Product Liability Suits

                                   Loss Year

   Year
     of
Experience
(ex. Year of
  Sales)


          2008 = 15 x 1.337 = 20    2010 = 25 x 1.1075 = 28
          2009 = 20 x 1.246 = 25    2011 = 28 x 1 = 28
                                                              55
  Development Factors


                        Development Period


   Year
    of
Experience




  Examples
  2003, y+1 = 16/12 = 1.33
  2003, y+2 = 20/16 = 1.25
                                             56
  Loss Development:
   2007 Sales Year

        2007: 15 Losses

2008:         15 x 1.337   = 20
2009:         20 x 1.246   = 25
2010:         25 x 1.107   = 28
2011:         28 x 1.000   = 28



                                  57
  Present Value Calculation
Determining Losses from 2003 Sales




                               58
   Homework Problems




• A) Determine the Number of Fully Developed
  Losses for 2004, 2005, and 2006.
• B) What is the PV of Losses Arising from
  2005 Sales as of 2005?
                                         59
Shapes of Different Distributions




 • Medical Expenditures
 • Church Fires
 • Parking Tickets


                               60
Normal Distribution


  • Bell Shaped

  • Two Parameters

  • Easy to Use


                      61
Property Losses



   • Property Exposed to Loss
   • Peril
   • Financial Consequences



                           62
Property Exposed to Loss


   [ Real Property

   [ Personal Property

   [ Non-owned Property

                           63
      Non-owned Property

•   Bailed Property
•   Leased Property
•   Property on Consignment
•   Employee’s Property
•   Property under Lien
•   Agency Relationships
•   Contingent Property
                              64
      Perils


• Commonly Insured

• Government Insured

• Uninsurable


                       65
Commonly Insured Perils 1


        •   Fire
        •   Lightning
        •   Windstorm
        •   Hail
        •   Explosion
        •   Smoke
                            66
Commonly Insured Perils 2

        •   Aircraft & Vehicle Damage
        •   Riot
        •   Vandalism (Malicious Mischief)
        •   Falling Objects
        •   Weight of Snow, Ice, or Sleet
        •   Water Damage
        •   Glass Breakage
        •   Sprinkler Leakage
        •   Perils of Transportation
        •   Crime Perils
                                             67
Difficult to Insure Perils


    • Earth Movement

    • Floods

    • Nuclear Reaction


                             68
Why Are Some Perils
  Uninsurable?

    • Against Public Policy

    • Under the Control of the Insured
       – Ex. Suicide

    • Probability of Loss is Too High

    • Simultaneous Destruction




                                         69
Generally Uninsurable Perils

 • War, Terrorism, Rebellion, and Insurrection

 • Intentional Losses

 • Fading, Rust, Dry Rot, Settling

 • Production, Marketing, and Political Risks
                                           70
    Financial Consequences

•   Reduction in Value
•   Debris Removal
•   Business Interruption
•   Contingent Business Interruption
•   Loss of Rental Income
•   Loss of Rental Value
•   Loss of Leasehold Interest
•   Inability to Reconstruct Records
•   Loss of Use Value in Improvements and Betterments
•   Demolition Costs and Increased Cost of Reconstruction
                                                    71
    Valuation of a Loss

• Market Value
• Replacement Cost
• Actual Cash Value
  – (Replacement Cost - Depreciation)
• Present Value of the Asset’s Contribution




                                              72
            Actual Cash Value
           Calculation: Building

• Purchase
  – Date: January 1, 1987
  – Price: $1,000,000
  – Expected Lifetime: 40 years


• Fire
  – Date: January 1, 2007
  – Replacement Cost: $2,000,000
                                   73
      Actual Cash Value
     Calculation: Building


• ACV = Replacement Cost - Depreciation
  –As of the Time of Loss

• ACV = $1,000,000 = $2,000,000 - $1,000,000



                                         74
Present Value of the Asset’s Contribution




                                            75
   Liability Loss

• Expenditure of TIME
  and MONEY
• Investigate, Negotiate,
  Defense, Payment




                            76
 Property Losses v.
  Liability Losses

• Parties Involved

• Measurement of Exposure

• Changing Environment

• Tail
                            77
Types of Legal Liability

• Criminal
  – Agent
  – Punishments
  – Insurance

• Civil
  – Private Duties
  – Common Law, Statutes, Contracts
                                      78
          TORT


• Wrongful Act or Omission

• Independent of Contract

• Legal Remedy: DAMAGES ($$$)

                             79
 Types of TORTS


• Intentional Torts

• Negligence

• Strict Liability
                      80
Intentional TORTS


• Legally Protected Right

• Intentional Interference
  – Voluntary
  – Damages Reasonably Foreseen
  – No Valid Defense

                                  81
Intentional Torts: Defamation


     • Types
       – Libel
       – Slander

     • Plaintiff Must Show
       – False, Injurious Statement
       – Publication
       – Damages

                                      82
  Defenses

• Truth

• Privilege
  – Absolute
  – Qualified
     •   No Malice
     •   Not Known False
     •   No Intent to Injure
     •   Fair, if by news media
     •   Covered Body
                                  83
      Intentional Torts:
Invasion of the Right of Privacy


     • Examples
       – Release Confidential Information
       – Hidden Microphones


     • Public Figures v. Private Figures



                                            84
Intentional Torts:
Assault and Battery

 • Assault
 • Battery
 • Defenses
   –   Consent
   –   Self-Defense
   –   Defense of Property
   –   Defense of Others
   –   Allowed Discipline

                             85
The “Preppy Killer”: Consent??

'Preppie killer' headed back to prison on drug rap
NEW YORK (AP) -- New York's so-called "preppie killer" is headed back to prison.

Robert Chambers already served 15 years behind bars for strangling a woman in
    Central Park during what he said was rough sex.

He pleaded guilty Monday to selling drugs. The Manhattan district attorney's office says
     Chambers is promised 19 years and four months in prison when he is sentenced on
     September 2.

Chambers and his girlfriend were charged with dealing cocaine out of their Manhattan
    apartment in 2007.

Chambers pleaded guilty in 1988 to manslaughter in the death of 18-year-old Jennifer Levin
    two years earlier.

    Stories portrayed him as a handsome, privileged, prep school youth gone bad.
He was released from prison in 2003.




                                                                                             86
Intentional Torts:
  Assorted Others

• False Arrest and Wrongful
  Detention
• Malicious Prosecution
• Trespass
• Conversion
• Nuisance




                              87
    Intentional Torts:
Assorted Others Continued

  • Wrongful Interference with a
    Business Relationship
    – Copyright Infringement
    – Deception

  • Bad Faith
    – Delaying Payment of Claims
    – Refusing to Pay Claims
                                   88
Negligence

• Acts of Omission

• Acts of Commission




                       89
Elements of a Negligent Act

• Legal Duty

• Breach

• Damages

• Proximate Cause
                         90
Damages

 • Compensatory Damages
   – Special Damages
   – General Damages
 • Punitive Damages




                       91
Defenses to Negligence

 •   Contributory Negligence
 •   Comparative Negligence
 •   Assumption of Risk
 •   Statute of Limitations
 •   Immunities
     – Sovereign
     – Charitable Institutions
     – Public Officials
                                 92
   Strict Liability Torts

• Abnormally Dangerous
  Instrumentalities
• Ultrahazardous Activities
• Dangerously Defective Products
• Workers Compensation Statutes
• Disability Benefit Statutes
• Aviation Law
• Dram Shop Laws
• Contractual Assumptions
                                   93
Goals of the Tort System



• Compensate

• Deter



                           94
Tort Reform Proposals


• Modify Joint and Several Liability

• Caps on Non-Economic Damages

• Caps on Punitive Damages



                                       95
The Work Relationship
• Employer
  – Sets Hours
  – Defines and Supervises Work
• Employee
  – Sacrifices Time for Income
  – Is Told How to Work
  – Method of Payment Not Important to
    Status
• Independent Contractor
  – Not an Employee
  – Controls Methods of Work
                                         96
      Workplace Injuries


• Common Law:
  Negligence
• Statutory Law:
  Workers
  Compensation


                           97
America’s Most Dangerous Jobs in 2004


  Rank   Occupation                                   Death rate/100,000   Total deaths

  1      Logging workers                              92.4                 85
  2      Aircraft pilots                              92.4                 109
  3      Fishers and fishing workers                  86.4                 38

  4      Structural iron and steel workers            47.0                 31

  5      Refuse and recyclable material collectors    43.2                 35

  6      Farmers and ranchers                         37.5                 307
  7      Roofers                                      34.9                 94

  8      Electrical power line installers/repairers   30.0                 36

  9      Driver/sales workers and truck drivers       27.6                 905

  10     Taxi drivers and chauffeurs                  24.2                 67      98
 Some Exceptions to
Workers Compensation

   • Small Firms

   • Farm Workers

   • Domestic Workers


                        99
Employers’ Common
    Law Duties

• Safe Place to Work
• Adequate Number of Competent
  Fellow Employees
• Provide Safe Tools and
  Equipment
• Warn of Inherent Dangers
• Make and Enforce Safety Rules
                              100
Workers Compensation

   • Accident

   • Arising Out of and In the
     Course of Employment

   • Only Bodily Injury

                                 101
   Workers Compensation
         Benefits
• Lost Wages

• Medical Care

• Body Part Payments

• Death Benefits
                          102
Exceptions to WC as Sole Remedy for
          Workplace Injury


     •   Assault by the Employer
     •   Retaliatory Discharge of the Employee
     •   Dual Capacity Doctrine
     •   Suits by 3rd Parties
         – Ex. Loss of Consortium
         – Ex. Consequential Injuries
     • Property Damage

                                                 103
Human Resource Exposures


   • Loss of Personnel

   • Cost of Employee Benefits




                                 104
Employee Benefits

• Attract Workers

• Retain Workers

• Retire Workers

• Encourage Productivity
                           105
Loss of Personnel

 • Premature Death

 • Disability/Poor Health

 • Resign

                            106
 Premature Death
Losses that Result

• Loss of Human Life Value

• End of Life Expenses

• Emotional Grief of Survivors


                                 107
     Premature Death
Risk Management Strategies

• Loss Prevention:
  – Medical Care
  – Good Health
• Life Insurance: Many are Underinsured
• Pension Plan
• Earnings of Surviving Spouse

                                   108
Estimating Human Life Value
Example: Worker 3 years from Retirement




                                      109
        Calculating Loss of
        Human Life Value
Worker dies at age 61 after being paid.
At the time of death 3 working years remained.




                                                 110
             Disability Problem

• Disability is comparatively frequent
• Disability can be extremely costly
• Most lost income due to disability is not
  replaced
• Disability insurance is confusing
   – Multiple definitions of disability
• Disability insurance is subject to moral hazard
   – Malingering

                                              111
Risk of a 90+ Day Disability v. Death
        During Working Years




                                   112
Risk Control

•   Avoidance
•   Prevention
•   Reduction
•   Information Management
•   Some Risk Transfers


                             113
Risk Avoidance


• Proactive Avoidance

• Abandonment




                        114
Drawbacks to Avoidance


   • Lost Benefits of Risk
   • Perhaps not Possible
     $ Government Imposed Risks
     $ Nature of the Risk
   • May Result in Worse Risks


                                  115
     Important Forms
    of Loss Reduction

 Salvage
 Subrogation
 Litigation Management
 Catastrophe (or Contingency)
  Plans
 Duplication
 Separation
                                 116
Information Management
     as Loss Control



 •   Customers: Enhanced Sales
 •   Creditors: Lower Debt Cost
 •   Suppliers: Better Relationships
 •   Owners: Greater Market Value

                                   117
     Risk Transfer

• Property or Activity Transferred

• Contractually Pass the Liability
  “Exculpatory Contracts”




                                     118
Government and
 Risk Control


  • Public Interest

  • Efficiency




                      119
 Risk Financing:
General Methods



   • Retention

   • Transfer



                   120
Risk Financing: Timing


  • Contemporaneous

  • Prospective

  • Retrospective

                         121
Approaches to Retention



   Passive or Unplanned

   Active or Planned



                           122
Retention: Funding Arrangements

   • No Advance Funding

   • Liability or Earmarked Accounts

   • Earmarked Asset Accounts

   • Captive Insurer
                                       123
Types of Transfers


  • Insurance

  • Noninsurance Transfers

  • Hedging

                             124
Elements of Insurance

    • Contract

    • Premium

    • Conditional Benefits

    • Pooling of Resources
                             125
    Insurance Transaction


• Buyer Side of the Market
  – Risk Managers
  – Brokers
  – Consultants
• Supplier Side of the Market
  – Insurance Company
     • Underwriters, Claims Adjusters, Agent, Actuaries
  – Agent

                                                          126
Noninsurance Transfers


• Do Not Satisfy Conditions to be
  Insurance

• Provide External Funding



                                    127
         Hedging

• Taking an Offsetting Risk

• Not Possible for Many Types of Risks




                                         128
129
130
131
          Hedging Example


January 1: Arrange to sell chairs for $5.00
           Raw materials today cost $2.50/chair

June 1:    Build chairs

July 1:    Deliver chairs


                                            132
           Hedging Example


Risk:       Cost of raw materials

Options:    1. Sell chairs on a cost + basis
            2. Buy and hold raw materials
            3. Buy and have seller hold raw
                      materials
            4. Use a hedge

                                               133
       “Futures” Contract

Owner of contract on Termination Date Receives the lumber

Price of contract depends on
a) Cost of lumber today
b) Risk Premium


Origination Date: September 1
Termination Date: August 31.




                                                            134
          Hedging Contract
January 1:   Buy Hedging Contract
             Hedging Contract = $2.50 + x
             Lumber = $2.50
             Risk Premium = x
June 1:      Buy Lumber & Sell Futures Contract
             Lumber = $2.50 + y
             Futures Contract = $2.50 + (x - z) + y
             Change in lumber cost = y
             Depreciation of risk premium = z
             Total Cost   = ($2.50 + x) + ($2.50 + y)
                          - ($2.50 + (x - z) + y)
                          = $2.50 + z               135
       Hedging Contract
      Numerical Example
Origination Date: September 1
Termination Date: August 31.
Original Risk Loading: 0.60

      x = .40
      x decreases .05 per month
      z = .05(5) = .25

Total Cost = $2.50 + .25 = $2.75

                                   136
Hedging Instruments for Financial Risks




                                          137
             Hedging Volatility


• Volatility is a measure of risk
• Some sources of volatility can be hedged
   – Interest Rate
   – Exchange Rate
   – Commodity Price




                                             138
            Interest Rate Volatility

• Debt is a key component of a firm’s capital structure
• Interest rate hedges can stabilize borrowing costs
• Some tools: forwards, futures, swaps, options




                                                          139
          Exchange Rate Volatility

• International businesses are exposed to exchange rate risk
• Tools for managing exchange rate risk
   – forwards
   – futures
   – swaps




                                                               140
          Commodity Price Volatility

• Costs of materials can be volatile:
    – Pricing becomes problematic
    – Sales demand becomes harder to predict


• Hedging allows for:
    – Better production decisions
    – Reduced volatility in cash flows


• Available tools (depending on the type of commodity):
    –   Forwards
    –   Futures
    –   Swaps
    –   Options


                                                          141
             Reducing Risk Exposure

• Hedging will not normally reduce risk completely
    – Typically, only price risk can be hedged  not quantity risk
    – Reducing risk completely causes loss of potential upside

• Timing
    – Short-run exposure can be managed in a variety of ways
    – Long-run exposure almost impossible to hedge




                                                                     142
                     Forward Contracts
• A contract between parties
    – Agreement today on the price of the asset on the delivery date
    – Delivery and payment is specified for a future date

• Forward contracts are legally binding on both parties

• Positions
    – Long:         Agrees to buy the asset on the future date
    – Short:        Agrees to sell the asset on the future date

• Key points
    – Negotiated contract
    – No exchange of cash initially
    – Usually limited to large, creditworthy corporations




                                                                       143
Payoffs on Forward Contracts




                               144
        Hedging with Forwards

• Forward contracts can virtually eliminate price risk

• New risk created: Credit risk of the counterparty

• Forward contracts are primarily used to hedge exchange
  rate risk




                                                           145
              Futures Contracts

• Futures traded on organized securities exchanges

• Upfront cash payment: MARGIN
   – Small relative to the value of the contract
   – “Marked-to-market” on a daily basis

• Clearinghouse guarantees contract performance

• Clearinghouse and margin requirements virtually
  eliminate credit risk

                                                     146
             Hedging with Futures

• Futures contracts are standardized
    – Allows for trading
    – Exact hedging may be difficult or impossible


• Credit risk is virtually nonexistent

• Futures contracts are available on
    –   physical assets
    –   debt contracts
    –   Currencies
    –   equities



                                                     147
                        Swaps

• A long-term agreement between two parties

• Can be viewed as a series of forward contracts

• Generally limited to large creditworthy institutions or
  companies




                                                            148
                          Option Contracts
•   The right, but not the obligation, to buy (sell) an asset for a set price on or before a
    specified date
     –   Call – right to buy the asset
     –   Put – right to sell the asset
     –   Exercise or strike price –specified price
     –   Expiration date – specified date

•   Buyer has the right to exercise the option; the seller is obligated
     – Call – option writer is obligated to sell the asset if the option is exercised
     – Put – option writer is obligated to buy the asset if the option is exercised

•   Options allow a firm to hedge downside risk, but still participate in upside
    potential

•   Pay a premium for this benefit

                                                                                         149
Payoff Profiles: Calls




                         150
Payoff Profiles: Puts




                        151
Retention vs. Transfer

•   Ability to Bear the Loss
•   Cost and Effectiveness of a Transfer
•   Degree of Control over the Risk
•   Insurance Loading Fees
•   Additional Insurer Services
•   Insurance as a Signal
•   Opportunity Costs
•   Taxes
                                           152
 Risk Financing Methods

• Guaranteed Cost Insurance

• Experience-Rated Insurance

• Retrospective Rating

                               153
Guaranteed Cost Insurance

 Underwriting

 Premium Depends on Classification Group

 Premium = (A)* (PURE PREMIUM) + B




                                       154
        Pure Premium

# cars = 10,000
# losses = 250
$ losses = $4.5 million
Pure Premium = frequency x severity
Frequency = 250 / 10,000 = 2.5%
Severity = $4.5 million / 250 = $18,000
Pure Premium = 2.5% (18,000) = $450
A = 1.4 B = $50
1.4 (450) + 50 = $680                155
Underwriting Considerations

      •   Adverse Selection
      •   Misclassification
      •   Control
      •   Civil Rights
      •   Costs of Classification
      •   Social Policy

                                    156
         What’s Fair and Why
Health Insurance Underwriting Factors



 •   Cigarette Smoking
 •   Obesity
 •   Age
 •   Prior history of heart disease
 •   Genetic Predisposition to Stomach Cancer
 •   Gender
 •   Race
                                            157
   State Underwriting Restrictions: Health
                Insurance

• CALIFORNIA:   Blindness, Gender, Marital Status, DES

• N. DAKOTA:    Blindness, Gender, Race

• WISCONSIN:    Blindness, Gender, Physical Impairment




                                                   158
         How Insurance Works
             An Example

Assume an individual has a 1% probability of getting
  cancer and incurring medical expenses of
  $200,000.

  How much would you charge to bear this risk?




                                                 159
      How Insurance Works


Central Limit Theorem
Mean = True Mean

Law of Large Numbers
Increase sample size by N
 New Mean = Old Mean x N
 New S.D. = Old S.D. x Sq. Root of N


                                        160
         HOW INSURANCE WORKS
        AN ILLUSTRATIVE EXAMPLE

Sample Size = 1,000
Mean = 10
S.D. = 2
Loss per claim = $200,000        S.D. Prob.
                                    1   68.27
                                    2   95.45
                                    3   99.73



    4     6   8   10   12   14                  161
   HOW INSURANCE WORKS
  AN ILLUSTRATIVE EXAMPLE
For 99.73% survival prob. insurer will charge:
     16 x $200,000 = $3,200
        1,000

Increase sample size to 100,000 (100x)
Mean # of Losses = 10 x 100 = 1,000
S.D. = 2 x sqroot (100) = 20

Now for 99.73% survival prob. insurer will
charge: 1060 x $200,000 = $2,120
            100,000                              162
         Requirements of an
           Insurable Risk

1.   Large Number of Homogenous Exposure Units
2.   Accidental
3.   Determinable and Measurable
4.   No Simultaneous Destruction
5.   Probability Calculable and Not Too High


 suicide, space shuttle, mental illness, war,
 early flight and computers, terminally ill

                                                 163
            Social and Economic
             Value of Insurance

•   Stability
•   Indemnification
•   Reduction in Reserve Funds
•   Insurers’ Ability to Invest
•   Satisfies Financial Requirements
•   Specialization in Loss Prevention

                                        164
Social Costs of Insurance


 • Insurers’ Operating Costs

 • Moral Hazard

 • Exaggeration of Losses


                               165
Cheating with Insurance


 • Insurer
   –   Failure to Honor the Contract
   –   Misleading Contracts
   –   False Advertising
   –   Inappropriate Sales

 • Insured
   – Fraud

                                       166
Controlling Cheating


    • Litigation

    • Regulation




                       167
             Litigation
Requirements of an Insurable Contract


     • Offer and Acceptance

     • Consideration

     • Competent Parties

     • Legal Purpose

                                    168
        Litigation
Legal Principles: Indemnity


• Valuation
  – Property: ACV
  – Liability: Actual Damages


• Apparent Exceptions
  – Valued Policies
  – Replacement Cost Insurance
  – Life Insurance

                                 169
  Actual Cash Value Example


ACV = Replacement Cost – Depreciation

1/1/04: Buy Machine for $3,000, 10 year life

1/1/06: Fire Destroys Machine; New Machine
        Costs $10,000

ACV = $10,000 - $2,000 = $8,000




                                               170
                  Litigation
    Principle of Insurable Interest

• Property and Liability: Time of Loss
  – Ownership
  – Potential Legal Liability
  – Secured Creditors
• Life Insurance: Time of Policy Purchase
  – Close Ties: Love, Blood, Marriage
  – Pecuniary Interest
                                         171
          Litigation
   Principle of Subrogation



• Prevents Double Indemnification

• Holds Down Insurance Costs



                                    172
           Litigation
 Principle of Utmost Good Faith


     • Representations
     • Concealment
     • Warranty


Is It Material?
                                  173
Why Is Insurance Regulated?


  • Advance Payment of Premiums

  • Complexity of Transaction




                                  174
Types of Regulation


 •   Licensing
 •   Solvency
 •   Rate Approval
 •   Agents’ Activities
 •   Insurance Contracts


                           175
Insolvency: Major Reasons


 •   Bad Management
 •   Poor Underwriting
 •   Inadequate Reserves
 •   Bad Investing
 •   Inattentive to Loss Prevention
 •   Competitive Pressures




                                      176
  Danger of Insolvency

• Most Insurers are Very Solid
• 100+ Years
   – 71 Life Insurers
   – 200 Property and Liability Insurers
• Guaranty Funds
• Buyout of Failing Firms




                                           177
Premium Regulation


   • Adequate

   • Fair

   • Reasonable

                     178
Methods of Rate Regulation

     • Prior Approval

     • File and Use

     • Open Competition


                          179
Advantages of Open Competition



•   Flexibility
•   Increased Availability of Insurance
•   Avoid Political Fights
•   Frees Time of Regulators



                                          180
Disadvantages of
Open Competition


• Price Gouging (?)

• Risk of Insolvency (?)

• Fair (?)


                           181
Regulation of Agents’ Activities


        • Licensing

        • Prohibited Acts
          – Twisting
          – Rebating



                               182
  Causes of Insurance
    Market Failure

• Adverse Selection
• Individuals Underestimate
  the Loss Potential
• Insurance Costs Too Much
• Pooling Not Possible
• Insurers Can Not Estimate
  the Loss Potential
                              183
THE END




          184