INFORM+INSPIRE

The Griffith Insurance Education Foundation

Risk Management Principles and The Role of Insurance

Washington, D.C. April 29th, 2013

James M. Carson, Ph.D. CPCU, CLU, ARMThe University of Georgia

Risk Focus on Fundamentals

Some review of familiar terms / concepts likely (see materials)

Plus some new thoughts / concepts Comments / Questions Welcome

The Griffith Insurance Education Foundation

Risk is Ubiquitous Personal/Individual Family Business Government

The Griffith Insurance Education Foundation

Risk Risk

The Griffith Insurance Education Foundation

Top 16 Most Costly Disastersin U.S. History(Insured Losses, 2012 Dollars, $ Billions)

$7.8 $8.7 $9.2 $11.1$13.4$20.0

$23.9 $24.6$25.6

$48.7

$7.5$7.1$6.7$5.6$5.6$4.4

$0

$10

$20

$30

$40

$50

$60

Irene (2011) Jeanne(2004)

Frances(2004)

Rita (2005)

Tornadoes/T-Storms

(2011)

Tornadoes/T-Storms

(2011)

Hugo (1989)

Ivan (2004)

Charley(2004)

Wilma(2005)

Ike (2008)

Sandy*(2012)

Northridge(1994)

9/11 Attack(2001)

Andrew(1992)

Katrina(2005)

Hurricane Sandy could become the 4th or 5th costliest event in US

insurance history

Hurricane Irene became the 12th most expense hurricane

in US history in 2011

Includes Tuscaloosa, AL,

tornado

Includes Joplin, MO, tornado

12 of the 16 Most Expensive Events in US History Have

Occurred Over the Past Decade

Insurance Information Institute. The Griffith Insurance Education Foundation

6

$8.3

$7.4

$2.6 $1

0.1

$8.3

$4.6

$26.

5

$5.9 $1

2.9 $2

7.5

$61.

9

$9.2

$6.7

$27.

1

$10.

6

$13.

6 $25.

0

$100

.0

$7.5

$2.7

$4.7

$22.

9

$5.5 $1

6.9

$0

$20

$40

$60

$80

$100

$120

89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11*20??

US Insured Catastrophe Losses

*Estimate through Oct. 31, 2011.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.Sources: Property Claims Service/ISO; Insurance Information Institute.

2011 was one of the Most Expensive Year in History for Insured Catastrophe Losses in the US

$100 Billion CAT Year is Coming Eventually

Record Tornado Losses Caused

2011 CAT Losses to Surge

($ Billions)

2000s: A Decade of Disaster2000s: $193B (up 117%)

1990s: $89B

The Griffith Insurance Education Foundation

Underwriting Gain (Loss)1975–2012:Q3*

* Includes mortgage and financial guaranty insurers in all years.Sources: A.M. Best, ISO; Insurance Information Institute.

Large Underwriting Losses Are NOT Sustainable in Current Investment Environment

-$55

-$45

-$35

-$25

-$15

-$5

$5

$15

$25

$35

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 09 10 11 12

Cumulative underwriting deficit from 1975 through

2011 is $479B

($ Billions) Underwriting losses

through 2012:Q3

totaled $6.7B

High cat losses in 2011 led to the highest

underwriting loss since 2002

The Griffith Insurance Education Foundation

What is Risk? Traditional Definition

Risk = Uncertainty Risk of Death?

The Griffith Insurance Education Foundation

What is Risk? A Better Definition

Risk = Uncertainty about chance, timing, or amount of loss Risk of ____ death Risk of poor health Risk of car accident Risk of house fire Etc…….

The Griffith Insurance Education Foundation

Types of Risk Objective risk v. Subjective risk Pure risk v. Speculative risk Property risk (direct v. indirect) Liability risk

(Ex: Corps of Engineers, Deepwater Horizon Spill)

The Griffith Insurance Education Foundation

The Burden / Cost of Risk on Society Need for Emergency Funds Outlays to Reduce Risk Opportunity Cost Expense of Financing Potential / Actual Losses Increased Prices Loss of Certain Goods & Services Worry and Fear Time Losses For Which We Are Not Indemnified

The Griffith Insurance Education Foundation

Benefits of Managing Risk Potential Enhancement of Credit Indemnification for Losses Less Worry and Fear—More Activity Source of Investment Funds

(~$6 T Assets) Loss Prevention Services

Private Efforts Public Efforts (Ex: flood mitigation)

The Griffith Insurance Education Foundation

The Griffith Insurance Education Foundation

Risk Management

Risk Management Definition:

Formal decision-making process to identify risk and minimize the cost of risk, including the potential financial consequences associated with loss exposures

The Griffith Insurance Education Foundation

Risk Management Process Identify loss exposures and select the most

appropriate techniques for treating such exposures

Broader than simply Insurance Trend toward “Enterprise Risk Management”

Loss Exposure: Any asset exposed to loss; any situation in which a loss

may occur

The Griffith Insurance Education Foundation

The Griffith Insurance Education Foundation

Risk Management Process

Implement and Monitor

Identify

Evaluate

Select a TechniqueAvoidRetainTransferControl

Insurance

Other Contractual

Evaluating Loss Exposures Loss Frequency

Car accident occurs every 5 _____ in U.S. For most drivers, though, low frequency, 1 in

10 years Loss Severity

Maximum Probable Loss Maximum Possible Loss

The Griffith Insurance Education Foundation

The Griffith Insurance Education Foundation

Select Appropriate Technique: The Risk Management Matrix

Frequency

Severity

High

Low

LowHigh

Retain Control/Retain

Insurance Avoid

Select an Appropriate Technique

Retention Why would you/someone/firm retain risk? How Much Can be Retained? (Financial Capacity) Active vs. Passive Retention vs. Self-Insurance (Formal) Disadvantages

The Griffith Insurance Education Foundation

The Insurance Mechanism Definition:

The pooling of fortuitous losses By transfer of risks to insurer Insurer agrees to indemnify for covered

losses

The Griffith Insurance Education Foundation

Basic Elements of Insurance Pooling of losses

Losses are shared by the pool Substitutes average loss ($xxx) for actual

loss ($30,000 car)

The Griffith Insurance Education Foundation

Basic Elements of Insurance Replaces uncertain loss (risk) with certain

payment (premium) Unique in that pricing before the fact—

don’t really know costs until after product is sold

Insurer uses law of large numbers and past experience to estimate premiums

The Griffith Insurance Education Foundation

The Griffith Insurance Education Foundation

Pricing of Insurance – An Analogy

Card Value # of Cards Prob Exp ValueNon-Face $0 36 0.667 $0Jacks/Queens -$100 8 0.148 -$15Kings -$250 4 0.074 -$19RedAces -$1,000 2 0.037 -$37BlackAces -$2,000 2 0.037 -$74RedJoker -$5,000 1 0.019 -$93BlackJoker -$20,000 1 0.019 -$370

54 1.000Average (Expected Value) -$607

• Substitutes average loss ($607) for actual loss

Insurance Prices (Rates) Objectives: Adequate, not excessive,

not unfairly discriminatory Conflicts among these goals

The Griffith Insurance Education Foundation

Insurance Prices (Rates) Methods vary by state and line of

business Personal lines generally are more strictly

regulated than commercial lines Often more concerned with rates that are

too low rather than too high Remaining insurers pay claims of failed insurers

The Griffith Insurance Education Foundation

Basic Elements of Insurance… Surplus

Insurer “Net Worth” = Owners’ Equity = A – L For U.S. P-C Insurance Industry, ~$600 B If, at end of the year (policy period):

Losses > expected, fund balance (“Surplus”) goes down

Losses < expected, fund balance (“Surplus”) goes up

The Griffith Insurance Education Foundation

Basic Elements of Insurance

“Surplus” is the Insurance Mechanism’s “Cushion” and is what enables insurers to offer insurance

Premium / Surplus ratio concept (leverage)

The Griffith Insurance Education Foundation

‘Requirements’ of an Insurable Risk Large Number of Homogeneous Exposure Units Accidental and Unintentional Loss Determinable and Measurable Loss Calculable Chance of Loss Economically Feasible Premium

If calculated premium is too high, probably trying to insure something that is best

_______ Best suited for risks that have __S and __F

The Griffith Insurance Education Foundation

Adverse Selection Definition:

Phenomenon whereby people with higher-than-average chance of loss are more likely to seek insurance than average risks (e.g., ……)

i.e., the non-face cards don’t buy insurance, then the pool doesn’t collect $607 * 36

The Griffith Insurance Education Foundation

Adverse Selection Consequences

Results in higher losses & expenses than expected

Prices increase “Better” risks drop out of pool, prices increase….

”Death Spiral”

The Griffith Insurance Education Foundation

Controlling Adverse Selection Underwriting

Involves selecting and classifying insurance applicants

Certain standards that must be met for “standard” rates

If better than “standard,” lower rate applies If < “standard,” higher rate applies

Policy Provisions E.g., Suicide clause in life insurance

The Griffith Insurance Education Foundation

Key Points about Adverse Selection

Risk pooling doesn’t work if the risk is too high Risk pooling doesn’t work with too many high

risks Insurers need to be able to identify risk type so

that they can put similar risks together in a pool to make it fair and affordable

Competition will drive premiums to the appropriate level for risk type

The Griffith Insurance Education Foundation

The “Moral Hazard” Problem Definition: Behavior change due to the

presence of insurance that increase the frequency or severity of loss

Examples: Faking accidents, disability Exaggeration of claims Failure to control losses (not locking car or

house) Intentional losses Overutilization of insurance (e.g. health)

The Griffith Insurance Education Foundation

Controls on Moral Hazard Can’t insure in excess of the loss Limits on underinsuring property Careful claims adjusting Deductibles and coinsurance Waiting periods Exclusions Limits Riders

The Griffith Insurance Education Foundation

Societal Costs of Insurance Cost of Claims Outlays to Reduce Risk (Loss Control) Increased moral hazard

Changes in behavior

The Griffith Insurance Education Foundation

Societal Costs of Insurance….. Cost of Ins. Mechanism --“Expense Load”

Cost (Expenses, Profits, Contingencies), including Inflated / Fraudulent Claims Insurers do not “pay” claims We pay claims Anything that increases outflow must have an

inflow EX: To insure expected losses of $5,000 would

require premium of more than $5,000; so, for example, $5,000 + ~20% = ~$6,000

The Griffith Insurance Education Foundation

Brief overview of Basel 3

Capital standards Primarily geared toward banks Gets applied to some insurers via Dodd-

Frank Act

The Griffith Insurance Education Foundation

Basel 3 cont… Authorizes Federal Reserve Board

regulation of Savings and Loan Holding

Companies (some of which own life insurers)

Nonbank Financial Companies (may include insurers that are deemed systemically important by the Financial Stability Oversight Council)

The Griffith Insurance Education Foundation

Basel 3 cont… Some Issues

Risk-Based Capital (RBC) and FAST exist for insurers

Long-term Assets vs. Short-term Assets

Bank-type regulation at federal level vs. insurer-type regulation at state level

The Griffith Insurance Education Foundation

Thank you. For more information contact:

The Griffith Insurance Education Foundation7100 North High Street, Suite 200Worthington, Ohio 43085

Phone: 855-288-7743Email: info@griffithfoundation.org

To download today’s presentation, please visit www.griffithfoundation.org/resources

INFORM+INSPIRE

The Griffith Insurance Education Foundation

Risk Management Principles and The Role of Insurance