Unit 4Risk Management

&Insurance

Today’s Learning ObjectiveWhat are the basics of risk management & insurance?

• Risk Basics• The Risk Management Process• Risk Reduction• Risk Transfer• Risk Retention• Insurance Basics• How Premiums are Determined

Risk• The uncertainty that a financial loss will

occur due to some event• Peril

– The risk for which you are obtaining insurance• Damage to car• Medical expenses due to having cancer• Etc.

• Hazard– The events that can cause a loss

• Auto accident• Accident in the home resulting in large medical

bills• Death due to old age/illness/injury• Someone breaking into your house

• Exposure– The amount of potential loss due to a

hazard– Example: If you get into a car accident, it is

the amount you might need to repair or replace your car.

• Liability– The dollar amount of damages should a

hazard occur that would be required to return someone/something to its condition prior to the occurrence of the hazard

– Example: You hit someone with your car. The liability is the amount you would need to pay to repair/replace that person’s car.

Risk Management

• The process used to manage risk exposures– The actions you take to deal with the

uncertainty of a potential financial loss• Step 1: Identify potential risks• Step 2: Make decisions & take actions

on how you will deal with risk

Step 1: Risk Identification

• Identify all potential risks– Identify every possible event that could

happen that could result in a financial loss• Identify loss exposure associated with

each risk– The amount you could potentially lose

based on that risk– Potential dollar value of that loss

Step 2: Decide How to Deal with Risk

• Determine what you will do in each of the following methods of risk management to deal with that risk:– Risk reduction– Risk transfer– Risk retention

Risk Reduction

• Actions taken to reduce the:– likelihood of a hazard occurring (called

frequency reduction)– severity of loss should hazard occur (called

severity reduction)

• Examples:– Hazard:

• shoplifting– Reduce by:

• move inventory farther from front door• install security cameras• use electronic loss prevention system

– Hazard:• damage to car

– Reduce by: • drive more slowly• drive safer car• don’t drive as much

• May choose risk avoidance– Decide not to take on (or no longer take

on) risk– Examples:

• Hazard: getting hurt or losing car in car accident

• Avoid by: don’t drive or get a car

• Hazard: someone get food poisoning & sue me after sampling food in my gourmet food store

• Avoid by: don’t give out food samples

Risk Transfer• Getting someone else to assume the

risk of the loss for you• Normally involves payment of money by

you to the other person of business to take on the risk that you will suffer a loss– You pay other person money– They assume risk

• If loss occurs, they pay for loss so you don’t have to

• Example:– INSURANCE

Risk Retention• You assume the risk of loss from to an

identified hazard yourself• Can assume all of risk associated with

potential hazard– Example:

• Hazard/Risk: financial loss due medical bills resulting from an accident/injury

• Retained by: not getting insurance and paying for medical bills out of your own pocket

• Can assume part of risk associated with potential hazard– Example:

• Hazard/risk: financial loss due to getting sued when you hit someone with your car

• Retained by: getting $50,000 in auto liability insurance…if you lose lawsuit for more than $50,000, you will have to pay that out of pocket

• Risk retention may be planned– You know the risk of a hazard exists– You choose to not reduce/avoid/transfer

that risk• Risk retention may be unplanned

– You fail to realize that the risk of a hazard exists

– You know the risk exists but assume hazard won’t occur

Fundamentals of Risk Transfer

• Basic terminology– transferor

• Person/organization transferring risk to other party

– transferee• Person/organization assuming risk from

transferor

• Transferee must be able to predict frequency of hazard occurrence & loss– Based on statistical averages, how often

can the transferee expect a specific hazard to occur

• Transferee must be able to predict severity of loss due to hazard– Based on statistical averages, how much

can the transferee expect to pay when a specific hazard occurs

• Law of Large Numbers– The larger the number of potential

transferors you take on, the more accurately you can predict the frequency & severity of a potential hazard

– Based on statistical probability– Transferee can more accurately predict the

amount it will have to pay for losses during a given time frame

• Pooling– The more people a transferee can gather,

the better it can utilize the Law of Large Numbers to accurately predict losses for pool

– If total amount of losses for pool can be predicted, transferee can spread losses among entire pool• Determine how much to charge each transferor

for risk transfer to cover those anticipated losses, other expenses, and profits

– Not all of transferors will suffer loss• The money they pay helps cover others’ losses• The money they pay helps cover their losses (if

they occur)

• Transferee must be willing to take on risk of loss– If loss cannot be accurately predicted

(cannot employ Law of Large Numbers and risk pooling), or loss will be more frequent or more severe than transferee can afford, they will not take on risk

• Not all loss can be transferred– Transferor expected to retain some risk– Transferee will limit exposure

• Maximum amount of a loss for which they will pay

• Require you to pay part of loss

Summary of Risk Transfer Principles

• Transferee must be able to pool enough potential transferors to be able to employ Law of Large Numbers to reasonably determine:1. Frequency of hazards for which risk is

being transferred

2. Severity of losses for hazards

• Transferee must be willing to assume risk to be transferred– Can afford risk– Can get transferor to pay enough for risk

transfer to help cover loss

• Not all risk can be transferred– Transferee will limit its exposure to

assumed risk

In-Class AssignmentRate the Risk

Most Common Method of Risk Transfer

Insurance

Insurance• A contract between you (transferor) and

the insurance company (transferee)• You transfer risk to insurance company

for any financial loss due to the occurrence of the hazard for which you got insurance:– automobile accident– health problems– death– stolen property

• They pay so you don’t have to

• Insurance only pays out the amount of the actual financial loss

• for example:– if you have $50,000 coverage for some type of

insurance and only suffer $20,000 in financial loss– the insurance company only pays the $20,000 in

financial loss you actually suffered• don’t overinsure

– if your personal property is only worth $5,000, don’t get $50,000 worth of insurance on it

– insurance will only pay you $5,000• Insurance company only gives you money to

repair/replace (auto & property only)– They do not repair/replace for you– They do not force you to repair or replace property

Insurance Terms• insurer - company that sells insurance

(transferee)• policyholder - the person or business

purchasing insurance (transferor)• insured - the persons or organization

covered by the policy• policy - the written agreement, or contract,

between the insurer and the policyholder• premium - the payment by a policyholder to

the insurer for protection against risk• claim – once loss is suffered by insured, this

is submitted to insurance company to pay for loss

• deductible - a maximum dollar amount you will pay if you file a claim with your insurance company (risk retention)– example: $250 deductible means you will

pay up to $250 per claim• $100 claim - you pay all of it

– don’t file this claim; it will just raise your premiums

• $800 claim - you only pay $250; insurance pays the rest

– the higher your deductible, the lower your premium will be• More risk retention on your part

• co-insurance - you pay a percentage of the total claim (risk retention)– example: $500 claim with 20% coinsurance

• you pay $100; insurance pays the rest

– the more the claim is to your insurance company, the more you pay• More risk retention on your part

How Premiums are Determined

• Based on RISK• The riskier the hazard is:

– the greater the likelihood that the insurance company will have to pay a claim on your policy

– the higher the amount the insurance company will have to pay for a claim

• The riskier a hazard is to an insurance company, the higher your premium– Risky people:

• Bad driver = high auto insurance• Smoker = high health & life insurance

– Risky things:• Expensive car = high auto insurance• Expensive stuff = high property insurance

• The more risk you retain, the lower your premium– Higher deductibles & co-insurance– Lower coverage amounts (limits of liability)

for insurance company