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The Griffith Insurance Education Foundation

Basic Principles of Insurance & Risk Management

University of Central Oklahoma

Finance – Insurance and Risk Management

Stuart MacDonald, Gerald Wilkins, Allen Arnold

Seminar for

Oklahoma State LegislatorsMarch 20, 2013

Seminar Agenda

Overview of Insurance Principles

Types of Insurance

Regulation and Legislation

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Overview of Insurance Principles

Definition of Risk The Role of Insurance Risk Pooling Adverse Selection Concept of Moral Hazard

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Definition of Risk

Risk refers to uncertainty

An unknown or unexpected event

Risk can be strategic, unintentional, systemic, fortuitous

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The Role of Insurance

According to the American Risk and Insurance Association, “insurance is the pooling of fortuitous losses by transfer of such risks to insurers, who agree to indemnify insureds for such losses, to provide other pecuniary benefits on their occurrence, or to render services connected with the risk” (Redja, p. 20, 2011).

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Characteristics of Insurance

Pooling of Losses

Payment of Fortuitous Losses

Risk Transfer

Indemnification

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Risk Pooling

Spreads the loss suffered by an individual over the whole group

Based on the Law of Large Numbers

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Payment of Fortuitous Losses

Unforeseen

Unexpected

Result of Chance

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Transfer of Risk

Pure risk transferred from an insured to an insurer for a fee (insurance premium)

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Indemnification

Restoring an insured to their approximate pre-loss financial position

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Concept of Peril and Hazard

A peril is the cause of a loss

A hazard is a factor that creates or contributes to a loss

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Physical Hazard

Physical condition that increases the frequency and/or severity of a loss

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Moral Hazard

Dishonest or deceitful statements or behavior in order to defraud the insurer, thereby increasing the frequency and/or severity of loss claims

Insurance fraud causes increases in premium rates for everyone

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Attitudinal Hazard

Carelessness or indifference to a loss, thereby increasing the frequency and/or severity of loss claims

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Legal Hazard

Characteristics of the legal system or regulatory environment that increases the frequency and/or severity of loss claims

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Adverse Selection

Tendency for insurance applicant with a higher than average loss potential (sub-standard risk) to acquire insurance protection at less expensive (standard risk) premium rates

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Characteristics of an Ideally Insurable Risk Large number of exposure units Accidental and unintentional loss Determinable and measurable Not a catastrophic loss Chance of loss must be calculable Economically feasible premium

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Risk Management Matrix

Low frequency and severity: Retention High frequency and low severity: Loss

Prevention and Retention Low frequency and high severity:

Transfer Risk (Insurance) High frequency and high severity:

Avoidance

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INFLATION-ADJUSTED U.S. CATASTROPHE LOSSES BY CAUSE OF LOSS, 1992-2011

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(1) Estimated property losses adjusted for inflation through 2011 by ISO using the GDP implicit price deflator. Excludes catastrophes causing direct losses less than $25 million in 1997 dollars. Does not include flood damage covered by the federally administered National Flood Insurance Program.(2) Excludes snow.(3) Includes wildland fires.(4) Includes losses from civil disorders, water damage, utility service disruptions, and any workers compensation catastrophes generating losses in excess of PCS's threshold after adjusting for inflation.Source: The Property Claim Services (PCS) unit of ISO, a Verisk Analytics company.

Why Insurers Become Insolvent

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Note that Fraud outranks Catastrophe Losses.

Types of Insurance

Personal Lines Life Health Homeowners Auto

Reinsurance and Surplus Lines

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Source: SNL Financial, Inc.

$502B

$576B

$175B

2011 U.S. Net Pre-miums Written

P&CLifeA&H

Personal Lines - Life

Life insurance is justified if others are financially dependent on the insured

Term Insurance vs. Whole Life Insurance Ownership Clause Incontestable Period / Suicide Clause Death benefit proceeds are tax-exempt Life Income Options / Annuities

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Personal Lines - Health

Patient Protection and Affordable Care Act

State Health Insurance Exchanges No pre-existing conditions No lifetime or annual limits Coverage for children to age 26

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2011 Life/A&H U.S. NPW by Line

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Source: SNL Financial, Inc.

Personal Lines - Homeowners Homeowners 3 (Special Form)

All-Risks Coverage, except named exclusions (Earthquake, Flood, War, Nuclear Radiation)

Homeowners 6 (Condominiums) Same as above

Homeowners 4 (Renters Insurance) Named Perils (NOT All-Risks)

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Personal Lines - Auto

Personal Auto Policy Liability Coverage Medical Payments Coverage Uninsured / Underinsured Motorists Collision and Comprehensive Exclusions (intentional injury or damage,

racing, road rage, business use, etc.)

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2011 P&C U.S. NPW by Line

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Source: SNL Financial, Inc.

State Trends in Auto and Homeowners Pricing 2011 report by the Insurance

Research Council indicates a rapid increase in the severity of claims, and a slow but steady increase in the frequency of non-severe claims.

Commercial Auto most stable underwriting

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Reinsurance

Primary insurer that writes the insurance transfers to another insurer (the reinsurer) part or all of the potential losses associated with such insurance

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Reasons for Reinsurance Increase underwriting capacity Stabilize profits Reduce the unearned premium reserve Protection against catastrophic losses

(e.g. reinsurers paid a large part of the $41 billion insured losses arising from Hurricane Katrina which significantly reduced losses paid by primary insurers)

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Surplus Lines Surplus lines refers to any type of

insurance for which there is no insurer licensed by the State of Oklahoma that will write the type and amount of insurance requested by the insured

Coverage must be placed by a surplus lines broker with a nonadmitted insurer which is not licensed to do business in Oklahoma (e.g. Lloyd’s of London)

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Surplus Lines

Surplus lines carriers are registered with the Oklahoma Insurance Department

A 6% surplus lines tax is levied on insurance premiums for surplus lines coverage; tax is paid by the surplus lines broker placing the coverage for the insured

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Regulation of Insurance

National Association of Insurance Commissioners (NAIC)

All 50 states, Wash. D.C, 5 US Territories Maintain insurer solvency Regulate fair and reasonable rates Ensure availability of insurance Consumer protection and education

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State Regulation of Insurance

Oklahoma Insurance Department Enforce insurance-related laws Protect consumers Promote competitive insurance markets License and educate insurance agents

and adjusters, funeral home directors, bail bondsmen, real estate appraisers

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State Guaranty Funds

Provide protection from losses if an insurer becomes insolvent

Life and Health Insurance Guaranty Association

Property and Casualty Insurance Guaranty Association

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Oklahoma Guaranty Associations

When a licensed insurer fails, other licensed insurance carriers are assessed according to the % of premiums they write in the State to pay the claims of the failed carrier

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Oklahoma Guaranty Associations

Each insurer who pays an assessment is permitted to take the amount they pay as a credit against their premium taxes (licensed insurance carriers pay a 2.25% premium tax on all premiums they bill their insureds)

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Solvency, Pricing, Rate Adequacy

Insolvency result of catastrophic losses, inadequate reserves and rates, mismanagement, bad investments, etc

Premium pricing function of expected losses, expense loading, investments

Rates regulated to balance insurer profitability and prevent consumer gouging

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Regulatory Methods to Ensure/Monitor Insurer Solvency

State insurance departments utilize strict methods and requirements to maintain insurer solvency

Licensing and financial requirements Risk-based capital standards Submission of financial statements In-field examinations of insurer practices

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Policy Forms

Insure Consistency of Product

Consistency of Interpretation of Language

Set Coverage Standards

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Balance between Consumers and Insurers

Government Failure vs. Market Failure

Bad Faith vs. Fraud

State Guaranty Funds vs. MoralHazard

Sound Underwriting vs. Red Lining

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Rate Filing

Interstate Insurance Compact

Must Insure Solvency

McCarran-Ferguson Act

Prevent “Destructive” Competition

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Issues in Insurance Legislation

Tag initiative uninsured drivers loss of state revenue

Workers Compensation

Captive Insurance

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Questions?

Comments?

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Melissa Kuhn Wheeler, The Griffith Insurance Education Foundation, (855) 288-7743, mwheeler@griffithfoundation.org

Dr. Stuart MacDonald, (405) 974-2152, smacdonald@uco.edu

Gerald Wilkins, (405) 974-5566, gwilkins@uco.edu

Allen Arnold, (405) 974-2171, aarnold1@uco.edu

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Thank you for allowing us to present this seminar on Insurance and Risk Management. Please contact us if we can be of further assistance.

This presentation can be downloaded at: www.griffithfoundation.org/public-policy/resources/