Discuss the difference between stock and mutual companies, reciprocal exchanges, and Lloyds associations Discuss the concept of indemnity as it app

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GENERAL PRINCIPLES OF RISK AND INSURANCE

CHAPTER 1

INTRODUCTION

What is The insurance transaction is a purchase of a contract (called theinsurance? insurance “policy”) that on behalf of the purchaser pledges the payment of a sum-certain amount (the “premium”) in exchange for a promise on behalf of the other party (the insurance company, or insurer) to provide restitution or indemnity arising from the occurrence of a loss. That is, the insurance transaction guards against the financial or economic repercussions arising from that occurrence.

Insurance is not wagering. When you gamble, you take a chance of losing money, but you also may break even or come out ahead. With insurance, on the other hand, there are only two possible outcomes: a loss or no loss. When you insure a home, it will either burn down or it won’t burn down. If you have insurance on it and there is a fire, the insurance will put you back in the same position you were in prior to the fire.

Some say that in purchasing insurance on a piece of real property (such as a home or business premises) or against some liability-producing event (such as physicians’ or attorneys’ malpractice), the purchaser is buying peace of mind with the knowledge that the economic hardship of a loss will be transferred to another party – the insurance company selling the coverage.

One classic definition of insurance is “a device for reducing risk by combining a sufficient number of exposure units to make their individual losses collectively predictable.” In other1

words, the losses of the few are shared among the premiums of the many.

This is an illustration of the “law of large numbers” which is the primary underpinning to the insurance mechanism. This is the principle that allows insurance to operate. The rule says that the more exposure units in the mix, the easier it becomes to predict the group’s losses. Flip a coin three times and it might turn up heads each time. Flip a coin one million times and it will likely be more evenly split between heads and tails. Take thousands and thousands and thousands of similarly situated units (like home owners, for instance) and you will be able to predict the losses that will occur in the group – and create a pool of financial resources (paid premiums) that allows for payment of the individual members of the group’s losses – and allows the insurer to turn a profit on the transaction.

The law of large numbers mechanism highlights the risk-transfer aspect of insurance. Another aspect of the definition of insurance says that insurance is a risk management technique – a means of budgeting a relatively small, known amount up-front cost (the premium) in place of a large – and possibly catastrophic – unknown future event (a

C o p y r i g h t 2 0 1 6 . T h e N a t i o n a l U n d e r w r i t e r C o m p a n y .

A l l r i g h t s r e s e r v e d . M a y n o t b e r e p r o d u c e d i n a n y f o r m w i t h o u t p e r m i s s i o n f r o m t h e p u b l i s h e r , e x c e p t f a i r u s e s p e r m i t t e d u n d e r U . S . o r a p p l i c a b l e c o p y r i g h t l a w .

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possible loss). Therefore, an adequate definition must include the transfer of risk to a third (the insurer), the accumulation of a fund to pay the losses, and a large enoughparty

number of similar exposure units (the insureds).

Another element to introduce into the insurance mix is the idea of fortuitousness. Non-fortuitous loss (those losses that are certain to occur) may not be insured. It is the concept of fortuitous acts that are insurable – a loss may or may not occur, so it may be insured; if the loss is certain to happen, it generally may not be the subject of an insurance policy.

In sum, insurance companies promise to indemnify the customer for accidental losses caused by certain perils. In exchange, the customer promises to pay the premium. On an aggregate level, insurers receive premiums from many people who buy insurance and pool them. They invest those premiums to earn more money, to pay its employees, to pay losses, and to earn a profit.

USEFUL DEFINITIONS

The following definitions are terms that are commonly used in every type of insurance policy. Their meanings in the insurance context may be similar to, but slightly different from how one might use them in everyday language.

A is the document that describes the types of coverage offered to the person whopolicy purchased the insurance (who are in turn referred to as “insureds” or “policyholders”). The description of the coverage is often dense and technical, and includes definitions of the coverage provided as well as declarations by the policyholder about who and what will be covered in the event of a loss.

is an important part of the insurance definition. It means, “to make wholeIndemnify again.” In other words, insurance puts the person back in the same position he or she was in prior to the loss – no better, no worse.

. Will’s 2012 Lexus (worth about $22,550) is damaged in an accident.Example The body shop estimates that it will cost $24,000 to fix it. If the insurer spends the $24,000 to repair the car, the insured will be better off after the loss than prior to it. When the insurer pays Will the $22,550 he is indemnified for his loss – he is paid an amount equal to what he lost. It’s a fair general statement that an item of property cannot be insured for more than it’s worth.

A is the amount of money that a policyholder pays the insurance company topremium provide a certain amount of coverage. Premiums are sometime paid all at once for coverage over a set period of time, or can be paid periodically to ensure ongoing coverage as described in the policy.

Peril, Hazard, and Risk: Not the Same Thing

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Before proceeding, the terms , and should be defined. Although theseperil, hazard risk three terms are often used synonymously by practitioners in the field, they do have differing technical meanings.

• may refer to uncertainty as to the outcome of an event when two or moreRisk possibilities exist, i.e., a building may stand or it may burn down. In property insurance, risk may also mean the physical units of property insured or the physical units of property at risk. For example, some might say, “the only risk the underwriter wants to take is fire on pig iron under water,” or “that fireproof concrete block building is a good fire risk.”

• A , in property & casualty insurance terms, is a . Forperil cause of a possible loss example, fire is a peril in property insurance, as is water damage, mold, earth movement, etc. A peril may be covered (coverage for the event is included under the policy) or excluded (coverage for the event is specifically excluded under the policy).

• A is a specific situation that increases the probability of the occurrence ofhazard loss arising from a peril or that may influence the extent of the loss. For example, fire, flood, and explosion are property perils – and liability itself is a peril under liability policies. Slippery floors, congested aisles, and oily rags in the open are hazards.

Non-Insurance Responses to Risk

People buy insurance to help them manage the risks in their lives. However, insurance is only one way to handle those risks. Some other methods of risk management are:

– occurs when one does not purchase insurance and decides to assume theRetention risk on his or her own. If a loss does not happen, the person saves the money that he or she would have spent on premiums.

A good example of retention is the decision not to purchase collision insurance on an older car. Retention requires that the insured do a careful analysis of what he or she can afford to lose. Some corporations use large retentions as a financial risk management strategy. For example, insurance coverage does not kick in until a loss has exceeded $25,000 or more. The insured saves on premium but has coverage for disastrous losses.

– involves either not doing something at all or getting rid of it or not doing itAvoidance any more. By relying on public transportation, one avoids the physical damage and liability risks of car ownership. By selling off a casino, a company is avoiding future losses from legislative changes that could negatively affect the casino.

– is the minimizing of hazards, the things that increase the chance of loss. ByControl putting a burglar alarm in the car, the owner is using the technique of control.

– is the transfer of risk to someone other than an insurer.Non-insurance transfer

. When renting tools, the customer signs a form promising to bring themExample

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back in the same condition. If he or she does not, the storeowner will charge the customer for those tools. The storeowner has used a non-insurance transfer to protect his property.

VOLUNTARY INSURANCE

In today’s market, there are two broad types of insurers – social and voluntary. Voluntary insurers are insurers that offer types of insurance that are not mandatory, and cover a wide variety of risks. These are what most people think of as “insurance companies,” and they offer the most common types of commercially available insurance:

• protects policy holders against damage to their property fromProperty insurance loss events such as fires, natural disasters, and accidents.

• protects policy holders against liability that may be imposed onLiability insurance them through the legal system, such as liability arising from their driving conduct or actions they take as employers.

• protect policyholders against theHealth, disability, and long-term care insurance financial consequences of ill health. This can include payment of medical bills, rehabilitation services, and replacement of income lost due to illness.

• provides financial benefits to loved ones (or entities such asLife insurance employers or charities) after the policyholders death. Due to the long time horizons involved in life insurance, policies have also grown to include investment-like vehicles including annuities.

These types of insurance can be purchased separately or together. For instance, a typical homeowners insurance policy (see ) includes significant coverageChapter 12 against both property and liability risks. The art of insurance planning involves helping clients choose (1) which insurance products to buy, and (2) how to purchase them.

Types of voluntary Insurers

The voluntary market provides an endless variety of coverages that are designed to meet almost any need. The four types of voluntary insurers are governmental, cooperative, self, and for-profit.

1. offer voluntary coverage on risks that the private marketGovernmental insurers may find too hazardous to insure. Such offerings include flood insurance, earthquake insurance, crime and fire insurance in the inner city, windstorm insurance in coastal states, crop insurance, and private passenger auto insurance for persons with very poor driving records. As examples, the National Flood Insurance Program offers flood insurance, California Earthquake Authority offers earthquake insurance, and the Texas Windstorm Insurance Association provides windstorm insurance to Gulf Coast property owners in Texas.

2. are also referred to as “fraternalinsurers.” That is becauseCooperative insurers

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they offer coverage only to their own members – such as a lodge, union, or religious organization. Fraternals are organized as not-for-profit companies. Examples of fraternal insurers include Thrivent Financial for Lutherans, Modern Woodmen of America, and Knights of Columbus.

3. is different from no insurance. Self-insurers are companies that setSelf-insurance up funds into which they make periodic payments. The self-insurance fund then pays losses for which the company is responsible. An advantage of self-insurance is that the company may incur lower costs than if it had purchased commercial insurance. Insurance companies are organized to earn a profit. The premiums that they collect go to pay for clients’ losses and the company’s expenses, such as salaries, office space, and supplies, as well as profit. The self-insurance payments do not include the charges for profit found in the premium from a commercial insurer. Companies that self-insure include Chevron, Costco Wholesale, Ford Motor, General Motors, International Paper, Tyson Foods, Wal-Mart Stores, and Walt Disney Company.2

In addition to lower costs, another advantage to self-insurance is that the company retains more control over its finances and operations.

In a true insurance program, the risk is transferred to a third party – the insurance company. In a typical self-insurance situation there is no real transfer of risk, but the risk is funded through the self-insurance program. For that reason, the preferred term is “retention,” as the organization “retains” its exposure to loss and pays losses out of that fund into which it has been making contributions.

4. are what most people think of as insurance companies. They areFor-profit insurers corporations (often publically traded and/or multinational) that offer various types of insurance with the goal of making a profit. Many for-profit insurers offer various types of financial services along with their traditional insurance products.

SOCIAL INSURANCE

Social insurers are government agencies that provide “social insurance” – protection against loss from unemployment, injuries, sickness, old age, and premature death. The three major types of social insurance are:

1. Old Age, Survivors, and Disability (commonly known as Social Security);

2. Workers compensation; and

3. Unemployment compensation.

What distinguishes social insurance from voluntary insurance is that participation is mandatory. The premiums paid are required by law and may be collected via payroll deductions referred to as FICA (Federal Insurance Contributions Act) and FUTA (Federal Unemployment Tax Act). Employees and employers both pay into the Social Security fund. Some employers are required to purchase both workers compensation insurance and unemployment compensation insurance. Employees are not assessed for workers compensation coverage but they may pay an unemployment tax (FUTA).

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: Clients who have household employees such as housekeepers, maids,Planning Note or babysitters may be required to withhold a specified amount for voluntary insurance.3

UNDERSTANDING THE NATURE OF RISK

While organizations face a multitude of complex risks, historically only risk wasevent deemed worthy of attention. “Event risk” is also known as “insurable risk.” Traditionally, insurers literally defined risk based on its insurability; if it can be insured, it’s either a “good” risk or a “bad” risk. If it cannot be insured, it’s a business risk, and thus considered just another cost of doing business.

Insurable risk is also known as . Fortuitous risk connotes solely the risk offortuitous risk loss; it does not contemplate the notion that (conceptually) risk cuts both ways. For example, an investment in stocks represents both the risk of loss and the risk of gain, also known as . While we generally do not associate the term risk with thespeculative risk possibility of a favorable outcome, that definition is just as valid as the fortuitous risk definition because each outcome represents deviation from the norm.

Regardless of the type, risk is just another way of defining . The words risk andvolatility volatility are essentially synonymous. The presence of risk denotes un , andcertainty uncertainty denotes volatility. Volatility is expressed as deviation from the expected. For example, if losses are forecast to be 10 percent, the volatility associated with the loss forecast can be expressed as a range between 8 and 12 percent. We use the term risk to define the degree of volatility as well as recognize the fact that volatility exists. Consider event risk in this context. If first-dollar (no significant deductible) insurance is used to transfer a particular event risk—for example, the risk of fire destroying a building—the volatility associated with the peril of fire has been removed. Assuming the insurance coverage and limits are appropriate, the insured has incurred a cost (the premium) for reducing the financial consequence of the risk of fire to effectively zero.

Next, consider the volatility associated with the risk that the building could burn to the ground in the absence of insurance. Of course, the volatility of the event does not change regardless of who ends up paying for the loss, but, in this case, it’s the building owner who must understand the volatility and manage it.

Historically, insurance has been the only viable alternative for managing fortuitous risk. The primary goal of the insurance mechanism is to restore the insured to its pre-loss condition. However, since insurance can be a costly method of managing volatility, other, potentially more effective techniques, have emerged over the years. The remainder of this chapter will discuss risk management as it applies to fortuitous risk. Other chapters in this book will address more advanced risk management concepts that consider all aspects of risk.

A Brief History of Risk Management

Risk management has been recognized as a viable technique for mitigating the effects of fortuitous loss to corporations and public entities since the early 1960s. Prior to that time, risk was not considered to be worthy of per se; it was generally handled bymanagement

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the purchase of insurance. The employee responsible for buying the insurance also had another primary function, for example, the treasurer, chief financial officer, safety manager or, in some cases, corporate counsel.

In the 1960s and 1970s reliance on insurance companies as sole providers of risk services began to wane. Visionary academicians such as Robert Hedges and George4

Head developed new ways of managing the myriad of risks faced by corporations and5

public entities. It was recognized that while insurance was an effective means of moving fortuitous risk off the balance sheet, there was no systematic approach to evaluating risk. The centerpiece of this research became known as the .Risk Management Process

THE RISK MANAGEMENT PROCESS

Managing risk does mean that every conceivable loss has been analyzed andnot factored out; to the contrary, risk management is primarily focused on the firm’s ability to recognize and correct faulty and potentially dangerous operations, trends, and policies that could lead to a catastrophic loss.

Risk management is, by definition, a that reflects an organization’s pre-loss exercise (see , “Claims Management Techniques”). In the same way,post-loss goals Chapter 9

financial planners review the potential risks (a pre-loss exercise) that could impact a client with the implied goal of minimizing the financial disruption of those risks to the client (post-loss goal) The risk management process does not occur in a vacuum; the degree to which risk is mitigated must be defined by the goals of the organization and the client.

The conventional risk management process is comprised of distinct steps orfive activities.

1. actual and potential risks facing the organization or client.Identify

2. actual and potential risks relative to their impact on theQuantify and analyze organization or client.

3. potential treatment options, including specific risk control measures andEvaluate risk financing techniques.

4. recommendations.Implement

5. the effectiveness of the chosen recommendations and Monitor make adjustments as necessary.

This chapter provides an overview of each step. Detailed discussions appear in later chapters.

Risk Identification

That which cannot be identified cannot be managed. Risk identification is the critical first step in determining exactly what constitutes a risk commensurate with the post-loss goals of the organization or client. In general, risks emanate from two major sources: assets and operations. These categories roughly define what are known as risks and first party third

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risks. The expression connotes risks associated with owned assets, whileparty first party the term indicates liability arising from operations.third party

Risks that must be financed or transferred (insured) in accordance with state law are generally considered and should be the first to be identified. These includebaseline risks injury to employees (workers compensation) and statutory requirements to fund the legal liability for or derived from operating motor vehicles (third-party risks).

Financial planners should be aware of the minimal requirements for coverage for their clients. For instance in Illinois, the minimum requirements for personal auto insurance are 20/40/15 ($20,000 in bodily injury coverage for each individual/$50,000 total bodily injury coverage/$15,000 property damage coverage) whereas in Pennsylvania, the minimum requirements for personal auto insurance are 15/30/5. covers more details onChapter 11 the meaning of these requirements.

Additional third-party risks include liability arising from operations, products, contractual obligations, and/or ownership of real property. As a general rule of thumb, third-party risks represent the greatest threat of financial loss to any organization. Automobile ownership represents both first- and third-party risks. Damage to the vehicle constitutes a first-party risk, while property damage or injury to persons (other than the driver) caused by operating the vehicle are third-party risks.

Quantitative Analysis

Risk quantification is accomplished through a variety of tools and methods. But, at its core, risk quantification means predicting the maximum and expected financial loss associated with each identified risk. For example, life insurance can be purchased to protect a surviving spouse in the event of premature death. The amount of life insurance can be based on the Human Life Approach, a Capital Needs Approach, or a Capital Preservation Approach. See for further clarification.Chapter 15

While physical assets allow relatively easy risk quantification, risks such as public liability and worker safety are considerably more difficult to quantify. When measuring third-party risks, organizations often ask two questions: “How much potential loss can we withstand as a result of this exposure?”, and “How much potential loss can we withstand and still remain

?” The answers to these questions will be dramatically different. Yet theyfinancially viable help to form the parameters of the risk management process.

Evaluating Risk Treatment Options (Financing & Control)

Having identified and quantified a variety of loss exposures deemed important enough to warrant action, the risk manager or financial planner must identify the options available to treat the exposures. Treating identified loss exposures is accomplished through two means: risk financing and risk control.

Financing

The spectrum of risk financing options is extremely broad. However, each financing technique falls into one of two major categories: (retention) and on-balance sheet

.off-balance sheet (risk transfer)

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Risks that remain on-balance sheet are known as retained risks. Those considered off-balance sheet have been transferred to an unrelated third-party, usually for financial consideration. Examples of on-balance sheet risks include insurance policy deductibles and self-insured loss exposures. Off-balance sheet transactions include insurance policies and contractual transfers of risk, among others.

The concept of differs significantly from that of . Self-insuranceself-insured uninsured connotes managing the loss exposure, such as establishing a fund from which to pay losses (also known as active loss retention)—for a client this may simply consist of

simply means that nothing hasemergency reserves and investment assets. Uninsured been done to recognize the exposure from a financial standpoint. Neglecting coverage for uninsured motorist and underinsured motorist is an example. The term ispassive retention also used in this context.

The primary example of off-balance sheet financing is insurance.

Control

Controlling risk means controlling the volatility inherent in organizational or individual life. For example, owning a boat represents a risk to its owners and operators. A boat without proper upkeep increases the potential for operator injury (increases volatility). Regular boat maintenance lowers the probability that the operator will become injured. Notice that the

itself (owning and operating a boat) is not controlled; the likelihood that the risk willrisk result in a loss controlled (its volatility).is

Transferring risks off-balance sheet does not constitute adequate risk control. This is because the transfer is not free. If the volatility of the transferred risk is not controlled, future transfer and/or financing costs will increase, along with the possibility that affordable (and available) financing and transfer options may become nonexistent. Using the boat ownership example, the boatowner operating the vehicle may be insured through a boatowner’s insurance policy (off-balance sheet). But, if the volatility associated with the boat is not controlled and people are repeatedly injured while using the boat for recreation, the boatowner insurance premiums will increase proportionately.

Risk control is the risk management activity. Without effective riskmost important control, financing and transfer techniques become virtually meaningless or prohibitively expensive.

Risk control is comprised of two main activities— and . Riskrisk prevention risk reduction prevention is only feasible if the person, thing, service, product, or operation capable of causing a loss is effectively removed or neutralized. In the above example, ownership of a boat can be avoided. So prevention is a reasonable risk control option. Risk reduction is most often associated with the notion of risk control. With a few precautions—such as regular boat maintenance and operator training—the risk of operator injury can be reduced.

Risk Administration—Monitoring and Adjusting

The final step in the risk management process is program oversight. Nothing remains static, especially the risks encountered by successful organizations. They must be monitored and adjusted continuously. (See Practice Standard 600 of the Financial Planning

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Practice Standards).

Continuous monitoring requires a structured approach that includes regular program reviews performed in conjunction with a reliable information. This step also should include planning for future contingencies such as market changes or changes with the client such as marriage, divorce, birth of a child, death of a loved one, etc.

Importance of Risk Management to the Organization

Risk management is an integral part of a successful organization’s overall management strategy as well as an integral part of a client’s wellbeing. In order to survive (and thrive) in today’s competitive economic environment, simply transferring every known risk via insurance is a viable option. Risk management has proven that the excessive use ofnot insurance can be an extremely expensive and inefficient use of capital. Since capital is the lifeblood of any organization as is cash flow to a client, it must be managed effectively. Risk management’s most fundamental contribution has been to provide senior management with an array of techniques designed to manage risk, and, by doing so, manage as well.capital While insurance plays a critical part, it is by no means the lone or lead actor. In fact, in the most sophisticated risk management programs, insurance plays a relatively minor role.

Large and complex organizations usually employ risk managers, and clients usually employ insurance agents and financial planners. The primary duty of a risk manager is to design and execute a management regimen in accordance with the pre-loss and post-loss goals of the organization and the process summarized in this chapter. Since risk management is a reflection of an organization’s culture, it must be considered in every important decision. The risk manager must have complete and unconditional support from senior management. Because risk permeates every facet of the organization, only senior management has the authority to enforce the requirements set forth in a comprehensive risk management program.

A risk management program can be costly to develop and implement. Senior management will lend its support only if the benefits are perceived to outweigh the costs. Likewise, clients will consider a long term care program that involves insurance only if the benefits outweigh the premium costs. The costs associated with risk management must be considered , because in most cases the benefits are only realized after aninvestments extended period of time. It is true that the initial costs may appear excessive given the minimal (if any) short-term return on investment. Senior management therefore must be willing to focus on long-term results.

It is extremely difficult to measure tangible benefits against a nonevent (i.e., the catastrophic loss did occur due to our highly effective risk management program). Yetnot this is the cha

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