insurance risk

INSURANCE AND RISK MANAGEMENT
SOLUTIONS TO STUDY QUESTIONS

CHAPTER 1: Nature of risk and its management

1. Explain the meaning of risk. In your explanation, state the relationship between risk and uncertainty.

Risk is defined as a condition where there is the possibility of an adverse deviation from an expected outcome. That is, there is the possibility of loss. Risk is a state of the real world in which a possibility of loss exists, while uncertainty is a state of mind characterised by doubt or a lack of knowledge about the outcome of an event. Risk can exist (as a state of the real world) even when danger is not perceived and where there is not any uncertainty. Additionally, uncertainty can exist where there isn’t any risk.

2. Risk may be sub-classified in several ways. List the three principal ways in which risk may be sub-classified and explain the distinguishing characteristics of each class.

Risk may be sub-classified as financial or non-financial, dynamic and static, fundamental and particular, and pure and speculative. The distinguishing characteristics of each class are discussed at ¶1-080 to ¶1-120 of the text. The distinction between financial and non-financial risks is very evident: financial risks have financial consequences, while non-financial risks do not. Dynamic risks are those that arise from changes in the economy, such as tightening of money supply while static risks exist even in the absence of economic change. Fundamental risks are those that are impersonal in origin, such as war and the consequences are generally beyond the control of the individual. Particular risks are personal in origin and consequence, such as fire damage to a dwelling and are generally considered to be the individual’s own responsibility. Pure risks are those in which there is a chance of loss or no loss only as opposed to a speculative risk where there is both a chance of a gain or loss.

3. How does objective risk differ from subjective risk?

Objective risk is a state of the world and reflects a variation of actual loss from expected loss. For example, a homeowner expects that there will be no loss to their home so the objective risk is that a variation to this expectation occurs, ie there is damage by a peril, such as wind damage during a storm.

Subjective risk is based on uncertainty about future events, such as the state of a road during heavy rain. It is based on a lack of knowledge about the future and is strongly influenced by one’s perception of risk. This perception is based on an individual’s opinion of uncertainty and may not be based on reality.

4. Explain in insurance terms why some situations have “more risk” or “less risk” than others.

The text’s definition of risk describes risk as an adverse deviation from an expected outcome. Therefore, the definition implies a variation around an average expected loss. It is this variation in possible outcomes that implies that some situations will have “more risk” or “less risk” than others.

5. Explain what is meant by the expression the range of error and how this relates to an insurer’s risk.

The term “range of error” is a statistical concept that gives an indication of how actual losses deviate from estimated losses. This deviation is called the standard deviation, which represents a measure of risk. For example, if an insurance company had 5,000 houses insured in their domestic portfolio and the actuary estimated that 50 homes will burn, the range of error may be that between 40 and 60 houses will burn and the insurer’s risk will be represented by the number in excess of 50 that burn. Statistically, the greater the number of exposure units, the more accurately the actuary will be able to predict expected losses with a greater degree of confidence and hence, the range of error will be reduced.

6. Briefly explain the law of large numbers and how this mathematical principle is relevant to an insurer’s operations?

Insurance companies base their premiums on their estimation of the number, say of homes that will be damaged in their portfolio of homes. Their portfolio is only a sample of the entire population of homes that may be available for insurance in the geographical area in question. If their portfolio only represents a small sample of the population then this could cause problems with their estimation, because estimation techniques rely on a large sample or observations for accuracy. The benefit of many observations is the foundation of the law of large numbers, which holds that as a sample of observations is increased in size, the relative variation about the mean (average) declines. Hence, predictions become more accurate.

7. Distinguish between ‘perils’ and ‘hazards’, and give two examples of each.

Perils are causes of loss, such as fire, wind, earthquake, flood, sickness and death.

Hazards are conditions that increase the probability of loss from a peril. Examples include faulty wiring, careless driving, sickness, improper storage of flammables, etc.

8. Hazards can be classified into two major groups. Explain the hazards contained in these groups.

These two major groups are: tangible hazards and intangible hazards.

Tangible hazards represent the physical hazards that are present in the environment that may increase the frequency or severity (or both) of a peril. For example, a person who smokes and is overweight increases the probability of dying before his/her statistical life expectancy.

Intangible hazards relate to peoples’ attitudes and non-physical cultural conditions that affect the frequency and severity of loss. Moral hazards represent deliberate acts to defraud an insurer and increase the probability of loss. Morale hazards represent an attitude of carelessness or indifference to a loss because of the existence of insurance. This attitude is not generally a result of dishonesty but a psychological tendency for people to show a lack of concern about protecting their property before a loss or caring for it after a loss. For example, failing to keep roof gutters clear of leaves is a hazard that increases the peril of damage by fire. Legal hazards refer to the increased probability of loss arising from court judgments or Acts of Parliament. An increasingly litigious society increases the frequency of hazard being sued and the severity of possible loss (peril).

9. Why may it be difficult in a particular situation to distinguish between moral hazard and morale hazard?

Dishonesty is a moral hazard while carelessness or lack of concern about a loss is a morale hazard. A careless person may leave the key in his/her car while it is parked, thus making it easy to steal. Similarly, a dishonest person who wants to have his/her car stolen may leave the key in it. The act is the same but whether it reveals a moral or morale hazard depends on the intention of the individual.

10. Some people with top-level health coverage visit doctors more often than required. Is this tendency a moral hazard or simply common sense? Explain.

This can be considered a moral hazard because it may be regarded as an overuse of medical services when a third party pays for the services. On the other hand, it may show a desire for prevention which may reduce the cost of health care coverage for more serious illness. It could be considered a case of exercising “common sense.” The question that should be asked is:
“Would you really go so often to the doctor if you did not have health insurance coverage?”
If answered “no”, then going to the doctor would be regarded as a moral hazard.

11. Explain the difference between dynamic and static risks. Give an example of each.

Dynamic risks represent risks that result from changes in the economy, such as changes in technology, prices and consumer tastes, which may cause financial loss to members of the economy. These risks are not predictable as they do not occur with any degree of regularity.

Static risks occur independently of economic changes and result from natural perils and dishonesty of individuals. Static losses are generally predictable, such as the frequency of fire in homes, burglary and theft, chances of dying or of being injured in an accident. Because of this predictability, static risks are generally insurable, while it is more difficult to insure dynamic risks.

12. Explain the difference between pure and speculative risk and between fundamental and particular risk.

Pure risks refer to those situations that involve the possibility of loss or no loss. For example, if a person owns a motor car there is a possibility of loss (the car will be damaged) or no loss (the car remains undamaged). Pure risks include damage to property caused by fire, lightning, flood, job-related injury, premature death, etc.

Speculative risk refers to situations that involve not only the possibility of a loss but also the possibility of a gain. While there is the possibility of a break-even, this is generally considered a loss because the objective of speculation is to make a gain. For example, a punter deliberately assumes risk in the hope of making a gain.

Fundamental risks affect the entire economy or large numbers of individuals or groups within the economy. The resulting losses are impersonal in origin, which cause losses that are caused mainly by economic, social and political phenomena. Examples include inflation and war because large numbers of people are affected and as such are considered the responsibility of government to provide protection in the form of social programs. On the other hand, particular risks only affect individuals and not the entire community. These may be static or dynamic risks and examples include car thefts and fires in dwellings. Losses caused by particular risks are the responsibility of individuals and can be dealt with through the use of insurance.

13. Inflation causes both pure and speculative risks in our society. Give some examples of each.

If a person puts his/her money in a locked box as a means of saving purchasing power, inflation exposes him/her to the pure risk that the purchasing power of such money will decline over time. Some commodities, however, increase in value far more rapidly than others as inflation progresses and people fear that it may be worse in the future. Gold is an example of such a commodity: when inflation increases, the price of gold sky-rockets; when there are signs that inflation is abating, the price of gold drops. While some people may be able to cope with the risks of inflation, most of us are not so fortunate. Some people go into debt to buy something that will increase in value in the hope of paying for it later with cheaper dollars. This, of course, exposes them to the risk that they may, because of unemployment or a bad turn of luck, be unable to pay off their indebtedness and lose their investment. They, in effect, exchange one risk for another.

14. List four types of risk that an individual or organisation faces.

The four types of risks facing the individual or organisation and an example of each include: personal risks – through death, sickness or disability property risks – damage to or destruction of property and the loss of use of property that has been damaged liability risks – liability suits arising from the use of cars, personal activities, etc risks resulting from human failure, or failure to perform – default of a debtor or failure of a contractor to complete a project contracted for.

15. What is the difference between a direct loss and an indirect or consequential loss?

Direct loss results from the physical damage, destruction or theft of property. For example, if a house is destroyed by fire, the owner loses the value of the property.

Indirect or consequential loss refers to the financial loss that results indirectly from a loss to exposed property, such as loss of rent, loss of gross profit or loss of customers.