Skip to content
Textbook Guides

Fundamentals of Risk and Insurance, 11th Edition Solution Manual

Take the stress out of textbook problems with Fundamentals of Risk and Insurance, 11th Edition Solution Manual, a complete guide to solving every question.

Preview 16 of 407 pages

See the first 16 pages exactly as they appear in the document.

  1. Page 1
    Read page 1 as text

    SECTION A CHAPTER NOTES AND ANSWERS TO END-OF-CHAPTER QUESTIONS - 9 -

  2. Page 2
  3. Page 3
    Read page 3 as text

    SECTION I RISK AND INSURANCE This first section of the book introduces the student to the basic principles of insurance. Chapters 1, 2, 3, and 4 deal with the subjects of risk, insurance, and risk management. The discussion of risk management is divided into two chapters, the first providing a general overview of risk management and the second deals with risk management decisions and specific risk management applications. Chapters 5, 7 and 8 treat institutional aspects of insurance, describing the various types of insurers, the manner in which they operate, their distribution systems, and some of the unique functions of insurers. Chapter 6 describes the regulation of the insurance industry. It traces the historical development of insurance regulation and describes current regulatory practices. It also discusses the issues related to the debate over state versus federal regulation. Chapter 9 discusses the law of contracts and other important legal principles associated with private insurance contracts. In our opinion, the critical chapters in this section are Chapters 1, 2, 3, 4, 5, 6 and 9. We believe that the material in these seven chapters should be covered in every course. The remaining two chapters may be covered as time permits. We consider Chapters 7 to be next in order of importance, and rank Chapter 8 last. - 10 -

  4. Page 4
    Read page 4 as text

    CHAPTER 1 THE PROBLEM OF RISK General Comments on the Chapter A discussion of risk—the basic problem with which insurance deals—logically precedes the discussion of insurance itself. This chapter introduces the concept of risk, defines it, and discusses the distinctions that can be drawn among the different classifications of risk. The definition of risk used in the text evolved over a period of many years, and grew out of a personal dissatisfaction with the definitions used in other books. It has always seemed to us that the definition of risk in an insurance course should immediately suggest to the reader the basic problem insurance is designed to solve, and that risk should not be a concept treated in the first chapter and then forgotten for the remainder of the book. Most people immediately recognize a situation in which a loss may occur as the basic reason for buying insurance. In simplest terms, risk is defined as a condition in which a possibility of loss exists. More specifically, risk is "...a condition in which there is a possibility of an adverse deviation from a desired outcome that is expected or hoped for." Defining risk as "a condition" seems to us to be both semantically and intuitively appropriate. It delineates the essence of the thing being defined and helps to emphasize the notion that risk is a state of the world created by a combination of circumstances. In addition, it more or less coincides with the intuitive notion of risk. Risk can exist (as a condition of the real world) even when the danger is not perceived and when there is no uncertainty. Uncertainty can exist in situations where there is no risk (that is, where the possibility of loss does not exist). In addition to establishing a formal definition of risk, the chapter stresses the distinctions among the various subclassifications into which risk may be divided. We believe that the most important of these are the "fundamental-particular" and the "pure-speculative" distinctions. The discussion of fundamental and particular risk is a convenient time to consider terrorism risk and the merits of the federal terrorism reinsurance program that was created following the terrorist attack on the World Trade Center. Some time should also be spent in distinguishing among the terms "risk," "peril," and "hazard," and in differentiating among the classes of hazard. This edition includes a discussion of “systemic risk,” reflecting the increased attention given to the concept in the aftermath of the recent financial crisis. The focus of this course is not on systemic risk, its cause, and the regulatory response, but it seems reasonable for students to have some exposure to the concept. In our experience, students are interested in learning about the financial crisis and its onset. Thus, the instructor may choose to take a brief detour to discuss AIG and its role in the crisis. A simple explanation in video form is provided at http://www.youtube.com/watch?v=DdEI6PkGZK8 . Alternatively, the instructor may prefer to defer the discussion to chapter 6, when the regulatory response is also presented. Because the video refers to credit default swaps as insurance, this is also an opportunity to discuss the the differences between insurance and credit default swaps, and the fact that AIG’s difficulty was not its traditional insurance business. This discussion is likely to be more clear to students after they have completed chapter 3, The Insurance Device. - 11 -

  5. Page 5
    Read page 5 as text

    The evolving nature of risk can often be illustrated with current events. Cyber risk is one area that is often in the news (As this is being written, Target is in the news for a cyber security loss, in which the credit and debit card information of up to 40 million customers was stolen in late November and early December 2013. The case is an excellent example of both cyber risk and reputational risk.) The section entitled The Burden of Risk explains why risk is a problem and briefly notes some of the detrimental aspects of risk. In discussing the burden or risk, we stress the dual-faceted nature of the burden; first, the costs associated with the losses that will actually occur, and second, the costs associated with the uncertainty regarding who and what will suffer loss. The uncertainty associated with risk creates the need to accumulate a reserve for contingencies (which involves an opportunity cost), deters capital accumulation, increases the cost of capital, and results in anxiety and worry. Important Concepts to be Stressed The most important concepts in the chapter, and the principles that we believe should be stressed in the lecture are: • The definition of risk as a state of the real world • The degree of risk • Risk distinguished from peril and hazard • Classification of hazards as physical, moral, and morale • The distinction between static and dynamic risks • The distinction between fundamental and particular risk • The distinction between pure and speculative risk • The concept of systemic risk • Classifications of pure risk • The burden of risk • The increasing frequency and severity of losses Answers to Questions for Review 1. Risk is defined as a condition in which there is the possibility of an adverse deviation from a desired outcome that is expected or hoped for. In simpler terms, it 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 characterized 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 the danger is not perceived and where there is therefore no uncertainty. Uncertainty can exist where there is no risk. See pages 2-3. 2. Risk may be subclassified as dynamic or static, fundamental or particular, pure or speculative, and systemic or nonsystemic. The distinguishing characteristics of each class are discussed in pages 6 and 7 of the text. Dynamic risks are those that arise from changes in the economy; static risks would exist even in the absence of economic change. Fundamental risks are those that are impersonal in origin and consequences—they are generally beyond the control of the individual. Particular risks are personal in origin and consequence, 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. Speculative risks involve the chance of loss or gain. Systemic risks affect an entire system and could cause cascading effects that disrupt other institutions. - 12 -

  6. Page 6
    Read page 6 as text

    3. The distinction between fundamental and particular risk is important because whether a risk is fundamental or particular may determine how society will choose to deal with it. Fundamental risks cannot usually be prevented, especially by the individual, and to the extent that they are beyond the control of the individual and affect large segments of the population, there may be a feeling that such risks are appropriate to the realm of social insurance or some other government program. However, it is also true that some fundamental risks may be dealt with through private insurance. Particular risks are usually more suited to treatment through private insurance, and are generally thought to be the individual's own responsibility. 4. The existence of risk may be a deterrent to economic activity and capital accumulation. Investors will undertake new risks only if the return on the investment is sufficiently high to compensate for both the dynamic and static risks. The cost of capital is higher in situations in which the risk is greater, and the consumer must pay the higher cost of the goods and services or they will not be forthcoming. See page 8 of the text. 5. The four types of risks facing the individual or organization and an example of each include Personal risks (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 out of the use of automobiles or otherwise); Risks resulting from human failure (default of a debtor or failure of a contractor to complete a project contracted for). See pages 7-8 of the text. 6. As the text points out on page 8, whether we define risk as the possibility of loss, uncertainty, or the probability that results will differ from what is expected, the greatest burden in connection with risk is that some losses will actually occur. Losses constitute a detrimental aspect of risk from the perspective of both the individual and society, since we lose want-satisfying goods. In addition, for the individual, there is the cost of preparing for the possible losses and the worry that generally accompanies risk. For society, risk may have a deterrent effect on economic growth by retarding capital accumulation. Risk increases the cost of capital, and the consumer must pay the higher cost of the goods and services or they will not be forthcoming. 7. Perils are causes of loss, and examples would include fire, wind, earthquake, flood, sickness, and death. A hazard is a condition that increases the probability of loss from a peril. Examples would include faulty wiring, careless driving, sickness, improper storage of flammables, and so on. 8. Hazards have traditionally been classified as physical, moral, and morale. Physical hazards include conditions such as faulty housekeeping, defective wiring, storage of flammables, obesity, and road conditions. Moral hazard is a dishonest tendency, and examples of moral hazard include businesses that are losing money, obsolete inventory that is overinsured, and similar temptations to defraud an insurer. Morale hazard is reflected in a careless attitude that may accompany the existence of insurance, or the inflated losses that occur simply because the loss is insured. For example, the tendency on the part of those with health insurance to spend more time in the hospital per illness than those without health insurance. The classification of hazards "is "physical, moral, and morale," is not exhaustive. For example, it has been suggested that we should add a fourth type of hazard, the " legal hazard ." Clearly, statutes, court decisions, and the legal environment are additional factors that can influence the probability of loss. - 13 -

  7. Page 7
    Read page 7 as text

    9. The number of risk increases over time because with changes in technology, new causes of loss and new hazards emerge. (See pages 8-10.) The text cites the transition from muscle, wind and waterpower to steam to electric to nuclear power and the increase range of perils as an illustration of this phenomenon. The development of new legal theories and rights also create risks, as has the transition to the information age. Cyber risk, in particular, is an increasingly important problem for individuals and society. 10. Earthquake - peril; sickness - both a peril and a hazard; worry - hazard, careless act - hazard; economic depression - hazard. The principal focus in discussing this question should be on the distinguishing characteristics of perils and hazards. A peril causes financial loss; a hazard increases the likelihood that a loss may occur from a peril. Thus, sickness is a peril that can cause loss of income, but it is also a hazard that can increase the likelihood of death. Careless acts and economic depressions are hazards that create the chance that economic loss may result from a lawsuit or from unemployment respectively. Answers to Questions for Discussion 1. Students' answers will vary, depending on the concept of risk that they hold. For those who define risk as uncertainty, there is clearly uncertainty in this situation, and the uncertainty with respect to the outcome of a past event constitutes risk to the same extent as would uncertainty regarding the outcome of a future event. Conversely, for the students who accept the text's definition of risk (as a condition in which the possibility of loss exists) risk does not exist in this situation because the outcome for both Tom and Tim is certain. 2. Mike's statement is true. For the individual, the possibility that the house may be destroyed by fire is a pure risk, because the possible outcomes include only fire or no fire. For the insurer that engages in the business of accepting the risks of individuals in return for a premium payment, the single exposure unit and the aggregate of all of the houses insured constitutes speculative risk. 3. In the case of gambling, as in the case of other speculative risks, the possibility of gain is the balancing factor. The gambler may also find the possibility of losing distasteful, but he or she incurs that possibility because it carries with it the possibility of a gain that is attractive. In addition, some would argue that it is not necessarily true that all people find risk distasteful; for some people it may be a delightful experience. One could conclude, however, that all forms of pure risk are distasteful, whereas risks of a speculative nature find favor among many people, and it is the possibility of gain that accounts for this difference. 4. Students answers will differ, but in general they should follow the pattern suggested by the four-fold classification discussed on pages 7-8 of the text (personal risks, property risks, liability risks and risks arising out of human failure). 5. Students answers may differ, but it may be expected that the students would find the 5% chance of losing $1,000 more distasteful than 50% chance of losing $100. This question provides an opportunity to discuss the concept of marginal utility, and also the critical role of severity in determining the importance of risks. - 14 -

  8. Page 8
    Read page 8 as text

    CHAPTER 2 INTRODUCTION TO RISK MANAGEMENT General Comments on the Chapter Prior to the ninth edition of the book, we deferred the discussion of risk management until the third chapter, after a discussion of insurance and how it works was introduced in the second chapter. We thought that an understanding of insurance and how it operates provided useful background for understanding why risk management represented an important break with the past. After 30 years, we came to share the opinion of those who prefer to introduce risk management before turning to the subject of insurance. Although this text is intended to focus primarily on pure risk, the increasing popularity of enterprise risk management cannot be ignored. The text distinguishes between enterprise risk management, financial risk management, and traditional risk management. Concepts such as market risk, credit risk, liquidity risk, and operational risk are discussed briefly. Finally, the text’s definition of risk management is no longer limited to the management of pure risks, but encompasses management of all risks. Note, however, that we maintain a focus on the management of pure risk in the remainder of the book. For example, the discussion of the role of the risk manager toward the end of the chapter focuses on traditional risk management – the management of pure risk. In discussing the evolution of risk management, the text follows the conventional explanation that risk management evolved from the field of corporate insurance buying, but goes further and attempts to explain why risk management emerged when it did. We believe that the appearance of risk management as an academic discipline owes much to the introduction of operations research and management science into the business college curriculum. The evolution of risk management was not inevitable, but required some external stimulus. Prior to the introduction of decision theory and the spread of its effect to other disciplines, little attention was devoted to the quality of risk management decisions. The insurance manager’s job was to buy insurance, and he or she would rarely be criticized for doing so. The real threat to an insurance buyer’s career was the uninsured loss and insurance buyers protected themselves as well as the corporation by buying more, rather than less insurance. Although some may disagree with the emphasis on the changes in decision making generally as the basis for risk management, we find no other explanation for the emergence of our discipline. In discussing the tools (techniques) of risk management, we have used the traditional terminology in classifying risk management techniques as risk control, which focuses on minimizing the risk of loss to which the organization is exposed, and risk financing, which concentrates on arranging the availability of funds to meet the losses that do occur. Although some instructors may prefer one of the more detailed approaches to classifying risk control and risk financing techniques, we have adopted the following classification system Risk Control Risk Financing Avoidance Retention Reduction Transfer - 15 -

  9. Page 9
    Read page 9 as text

    In this scheme, risk sharing is viewed as a special case of risk transfer, in which the risk is transferred from the individual from the group. (It may also be a form of risk retention, depending on the success of the risk sharing arrangement). The final section of the chapter is a brief discussion of the risk management process. Although most of the material in this section is similar to standard treatments of this subject, there are some differences. One is the addition of "Determination of Objectives" as the first step in the risk management process. We believe that this focus on planning and objectives adds a managerial emphasis that is otherwise lacking. Another area that we prefer to address early in the course is what we have termed in the text the two misconceptions about risk management. The first is that the risk management concept is applicable principally to large organizations. The second is that the risk management approach to dealing with pure risks seeks to minimize the role of insurance. The first misconception—that risk management is concerned exclusively with the problems of giant organizations—arose because much of the early literature in the field came from insurance buyers in giant organizations and addressed the problems with which they were concerned. With respect to the notion that insurance seeks to minimize the role of insurance, the argument is semantic. In the sense that insurance is a last resort, it can be argued that risk management does relegate insurance to a different role than previously. On the other hand, there are cases in which insurance is the most effective and suitable tool for addressing risk. Important Concepts to be Stressed The most important concepts in the chapter, and the principles that we believe should be stressed in the lecture are: • The development of risk management • The distinctions between enterprise risk management, financial risk management, and traditional risk management • The revision of business college curricula and decision theory • Decision theory, risk financing and risk control as elements of risk management • The distinction between risk management and insurance management • The steps in the risk management process • The nonprofessional risk manager • Risk management and the Individual Answers to Questions for Review 1. The three specialties that are merged in risk management are decision theory, risk financing, and risk control. Decision theory has its roots in operations research and management science. The risk-financing specialty came from the disciplines of finance and insurance, and the risk control specialty represents the merger of traditional safety management and loss prevention, as developed by the insurance industry, and systems safety from the military and aerospace industry. See page 15. 2. The two broad approaches to dealing with risk recognized by modern risk management theory are risk control and risk financing. Risk control focuses on minimizing the risk of loss to which the firm is exposed, and includes the techniques of Avoidance and Reduction. Risk - 16 -

  10. Page 10
    Read page 10 as text

    financing concentrates on arranging the availability of funds to meet losses arising from the risks that remain after the application of risk control techniques, and includes the tools of Retention and Transfer. See pages 17-20. 3. The four basic techniques available to the risk manager for dealing with the risks are avoidance, reduction, retention, and transfer. Avoidance and reduction are risk control techniques, while retention and transfer are risk financing techniques. Risks are reduced to the extent possible through avoidance and reduction; what remains after risk control efforts are implemented must be financed. The choices are retention or transfer, collectively exhaustive and mutually exclusive. What is not transferred is, by definition, retained. See pages 17-20. As noted in footnote 12 on page 20, some writers include a fifth technique, sharing. We believe that risk sharing is actually a special variation of risk transfer (and sometimes retention). In risk sharing, risk is transferred from the individual to a group, where it is shared, but it is transfer from the perspective of the transferor. For the members of the group collectively, sharing is actually a form of retention. 4. The change in philosophy that marked the transition from insurance management to risk management occurred when the attitude toward insurance changed. For the insurance manager, insurance had always been the standard accepted approach to dealing with risks. The insurance manager viewed insurance as the accepted norm or standard approach to dealing with risk, and retention was viewed as an exception to this standard. The insurance manager contemplates his or her insurance program and asks "are there any risks that I should retain?" "How much will I save in insurance costs if I retain them?" In viewing loss prevention measures, the insurance manager asks, "How much will this measure reduce my insurance costs?" "How long will it take for a new sprinkler system to pay for itself in reduced fire insurance premiums?" Rather than asking, "which risks should I retain?" the risk manager asks, "which risks must I insure?" The difference is obviously one of emphasis. The insurance-management philosophy views insurance as the accepted norm, and retention or non-insurance must be justified by a premium reduction that is, in some sense or another, "big enough." The risk manager, in contrast, views insurance as simply one of several approaches to dealing with pure risks. Under the risk management philosophy, it is insurance that must be justified. Since the cost of insurance must generally exceed the average losses of those who are insured, the risk manager believes that insurance is a last resort, and should be used only when necessary. 5. The six steps in the risk management process are: (1) Determination of objectives, (2) Identification of risks, (3) Evaluation of risks, (4) Consideration of alternatives and selection of the risk treatment device, (5) Implementation of the decision, and (6) Evaluation and review. See page 24. 6. Risk management evolved from insurance management. The primary motivation for the creation of insurance departments and insurance managers was the increasing cost of insurance. The evolution of decision theory and operations research led to a more widespread acceptance of the scientific approach to decision making and especially decision making under conditions of uncertainty. Prior to the development of the decision-theory models, there was a tendency to judge decisions under conditions of uncertainty based on whether the decision turned out to be right or wrong in some after-the-fact sense. Decision theory provides a basis for judging the goodness or badness of decisions before the outcome is known. - 17 -

  11. Page 11
    Read page 11 as text

    The transition from insurance management to risk management occurred over a period of time, and paralleled the development of the academic discipline of risk management. It is not clear whether the academic discipline led or followed, because developments in the corporate sector and the academic world appear to have occurred simultaneously. It is an exaggeration to suggest that risk management originated in the academic world. It grew from a merger of engineering applications in the military and aerospace programs, financial theory, and insurance. Many of the concepts of modern risk management that originated in academic halls, however, were taken over and applied in the corporate world. See pages 13-15. 7. The actual responsibility of the risk manager varies depending on the organization. Some risk managers have overall responsibility for all risk control and risk financing activities, including the firm’s employee benefit plan. In other cases, various parts of the risk control function, for example, may be assigned to a director of safety or a security director. Most risk managers are located in the finance department, but some may be found in a personnel or production division. There is a trend toward risk managers reporting to an executive vice president or even president. Page 22 - 23. 8. As noted in the text, the terms "insurance manager" and "risk manager" are often used interchangeably, without a great deal of attention to the actual role of the individual. One feature that distinguishes risk management from insurance management is the type of risks that each addresses. Because risk management evolved from insurance management, it is concerned primarily with insurable risk. Although the major focus of most risk managers is on insurable risks, the more appropriate realm of risk management is pure risk. In other words, the risk manager cannot ignore those pure risks that are not insurable. The text cites shoplifting losses as a type of loss that is rarely insurable, but with which the risk manager should be concerned. Risk management is, therefore, broader than insurance management, in that it deals with both insurable and uninsurable risks. Risk management also differs from insurance management in philosophy. Insurance management involves techniques other than insurance, but in general these other techniques are considered primarily as alternatives to insurance. Under the risk management philosophy, insurance is viewed as simply one of several approaches for dealing with the pure risks the firm faces. Whereas the insurance manager views insurance as the accepted norm or standard approach to dealing with risk, and retention is viewed as an exception to this standard. The risk manager, in contrast, views insurance as simply one of several approaches to dealing with pure risks. Rather than asking, "which risks should I retain?" the risk manager asks, "which risks must I insure?" The difference is one of emphasis. The insurance-management philosophy views insurance as the accepted norm, and retention or non-insurance must be justified by a premium reduction that is, in some sense or another, "big enough." Under the risk management philosophy, it is insurance that must be justified. See pages 20-21. 9. The two common misconceptions about risk management are the notion that risk management is concerned primarily with the risks of giant industrial organizations and that there is an anti-insurance bias in the risk management philosophy. See page 23. The first misconception—that risk management is concerned primarily with the risks of giant organizations probably developed because much of the literature in the field came from practicing risk managers. These authors naturally wrote about the problems with which they were concerned, such as self-insurance plans, captive insurers, and other techniques that do apply primarily to giant - 18 -

  12. Page 12
    Read page 12 as text

    organizations. In fact, the risk management philosophy and approach applies to organizations of all sizes and to individuals as well for that matter. The second misconception about risk management--that it is anti-insurance in its orientation and that it seeks to minimize the role of insurance in dealing with risk--also stems from risk management literature. Again, many writers from the academic world have sought to avoid writing about insurance in their discussions of risk management. In an effort to avoid writing insurance books and teaching insurance courses, some academics in the insurance field relegated insurance to a subordinate role in the risk management process, and focused instead other approaches to dealing with risk, such as risk control, risk retention, risk avoidance, and captive insurance companies. Contrary to the popular notion, the essence of risk management is not on the retention of exposures. Rather it is on dealing with risks by whatever mechanism is most appropriate, and in many instances, commercial insurance will be the only acceptable approach. While the risk management philosophy suggests that there are some risks that should be retained, it also dictates that there are some risks that must be transferred, and insurance plays a central role in the risk management process. 10. The term risk management is increasingly used to describe the management of speculative risk, particularly by persons in the field of finance. Financial risk management involves management of financial risks as market risk, credit risk, and interest rate risk. Enterprise risk management is broader, and would bring together the management of all risks—financial, operational, including traditionally insured hazards, and strategic—into a single portfolio. Traditional risk management is responsible primarily for managing pure risks (or operational risks). See pages 15-16. Note that ideally, the traditional risk manager should be involved in decisions relating to the overall operation of the organization for the purpose of evaluating various courses of action from the pure risk perspective. For example, the decision to manufacture a new product line or move into a new area of operations will inevitably involve new pure risks. The decisions relating to these strategies should include appropriate consideration of these pure risks, ideally before the decision is made. Answers to Questions for Discussion 1. The areas in which a risk manager should be knowledgeable are reflected in the techniques for dealing with risk; risk control and risk financing. It would seem that a well-rounded risk manager should have some knowledge regarding loss prevention and control techniques. Similarly, one would expect a risk manager to have a good understanding of risk financing options, with a solid understanding of insurance and how it works. Because risk management is basically a problem in decision-making, the risk manager also needs to understand decision theory. Because risk management encompasses so many fields, it is obviously difficult for one to be an expert in everything related to risk management. Most risk managers tended to be specialists in one particular phase of risk management (e.g., insurance or loss prevention) or generalists without expertise in any of the specific sub-disciplines of risk management. Although the study of risk management does not attempt to create experts in all risk-management fields, it does address the interrelationships of the techniques of risk management. More importantly, it creates a conceptual - 19 -

  13. Page 13
    Read page 13 as text

    framework that assists in the choice among risk management alternatives. In short, the emphasis in the study of risk management is on management in the decision making sense. Persons trained in risk management are uniquely equipped for organizing, planning, leading, and controlling the risk management functions of the organization. 2. Although the question asks for the student’s opinion, hopefully students will argue for a centralized approach to dealing with risks. Centralized risk management can produce economies of scale by consolidating insurance purchases when risks are transferred. In addition, there is likely to be a greater consistency in the approaches to dealing with risk in a centralized program. Finally, centralized risk management can facilitate pooling of risks for retention purposes. Students may suggest some advantages that could arise under a decentralized risk management program, but they will generally be slight compared with the advantages of a centralized approach. 3. Students who are taking their first course in the risk management and insurance sequence may not yet agree on the importance of the discipline in the overall education of business students. Most surveys of students who have completed the course indicate that students believe that the subject should be compulsory. Although the other functions in Henri Fayol’s classification of business functions have all received the approbation of inclusion in the AACSB common body of knowledge, risk management remains an optional elective. 4. Risk management can contribute directly to profit by controlling the cost of dealing with risk. In the terminology of responsibility accounting, the risk management division is a cost center, not a profit center, but by reducing the cost of dealing with risk, risk management can contribute directly to profit. The optimum combination of risk management techniques minimizes the net cost of pure risks to the firm. Reducing the cost of losses contributes directly to profits by reducing expenses for a given amount of revenue. To the extent that the risk management function allows the firm to engage in certain speculative risks by minimizing the impact of pure risks associated with such speculative risks, it also contributes directly to profit. 5. As noted in the text, a growing number of writers have argued that the traditional focus on pure risks is too narrow, and that the firm should have someone focused on enterprise risks, including both pure and speculative risks. This trend is particularly evident in industries such as banking and insurance, where financial risk is significant. On the other hand, many risk managers (perhaps even most risk managers) feel sufficiently challenged by their responsibilities relating to the traditional classes of pure risk. Ironically, there are many organizations in which the risk manager’s responsibility does not include all aspects of the management of pure risk. Often, responsibility for risk control lies elsewhere in the organization, and the risk manager’s responsibility is limited to the risk financing function, with only incidental responsibility for risk control. Rather than expanding the risk manager’s responsibility to include speculative risks, it may be more reasonable that risk managers pursue an expansion of their duties to include risk control. An important question is whether anyone else in the organization is interested in having the risk manager branch out into the management of market and credit risk. - 20 -

  14. Page 14
    Read page 14 as text

    CHAPTER 3 THE INSURANCE DEVICE General Comments on the Chapter This chapter introduces the student to the insurance mechanism and the manner in which it operates. It defines insurance from the viewpoint of both the individual and from the viewpoint of society, and stresses the notion that the essence of insurance is the transfer of risk and the sharing of the losses that do occur on some equitable basis. The discussion of the law of large numbers and probability theory is very basic, and even those students with little or no statistical background should have little trouble with it. In discussing the requirement of a large number of insureds, we point out that the large number does not relate only to predictability. The law of large numbers is important in achieving predictability but predictability is important only when the insurance is to be conducted on an advance premium basis. In post-loss assessment programs the requirement of a large number of exposures still applies, since there must be a large number of insureds who do not suffer loss who will pay the losses of the few who do suffer loss. The section entitled Insurance: Transfer or Pooling (page 41) addresses the question whether the essence of insurance is transfer or pooling. The discussion points out that transfer is the essential feature of insurance, and that while pooling is an important technique available to the transferee, it is not an essential feature of the insurance mechanism. The brief discussion of "self-insurance" points out the semantic difficulties inherent in the concept, and at the same time provides a workable definition for this widely used term. Although the term "self-insurance" poses certain semantic difficulties and conflicts with the usual definitions of insurance, the term has found widespread acceptance and those who use it know precisely what they mean. The term is widely used in state statutes (e.g., most state workers compensation laws permit "self-insurance,") and in insurance contracts (such as umbrella policies which refer to the "self-insured" retention). The final section of the chapter provides an overview of the forms that insurance can take. The major distinction is, of course, the distinction between social insurance and private or voluntary insurance. We have added a third class, Public Guarantee Insurance Program to encompass a residual class of insurance plans that do not fit precisely into the private insurance or social insurance classes. With respect to the distinction between private insurance and social insurance, the definition of social insurance proposed by the Committee of Terminology quoted in the text remains the best catalogue of the distinguishing characteristics of social insurance. With respect to what we have termed "private" or "voluntary" insurance, neither term in itself is wholly satisfactory or completely defines the class of insurance contemplated. Private insurance is usually—but not always voluntary, and voluntary insurance is usually—but again not always— sold by private insurers. In addition to distinguishing between social and private insurance, the chapter also gives a bird's eye overview of the fields of private insurance, subdividing the field into - 21 -

  15. Page 15
    Read page 15 as text

    the three areas of life insurance, accident and health insurance, and property and liability insurance. The third classification, "Public Guarantee Insurance Programs," fills what we consider to have been a previous void in the classification system. Programs like the FDIC, the Securities Investor Protection Corporation and the Pension Benefit Guarantee Corporation are clearly an application of the insurance principle, yet they do not fit conveniently under the traditional headings of social insurance or private insurance. They represent quasi-government plans that use the insurance mechanism to meet a specific security need. Generally, there is no contract and those who become entitled to receive benefits gain this entitlement as a matter of law rather than by contract. Because this chapter introduces the topic of social insurance, there is a temptation to address some of the problems facing the social security system here. It seemed more reasonable, however, to defer this discussion until Chapter 11, where the Old-Age, Survivors, Disability and Health Insurance (OASDHI) program is discussed in greater detail. Important Concepts to be Stressed The most important concepts in the chapter and the principles that we believe should be stressed in the lecture are: • The definition of insurance from the viewpoint of the individual • The definition of insurance from the viewpoint of society • Probability theory and the law of large numbers in insurance • The dual application of the law of large numbers • The desirable elements of an insurable risk • Randomness and adverse selection • The economic contributions of insurance • The concept of "self-insurance" • The distinction between private insurance and social insurance • Public guarantee insurance programs Answers to Questions for Review 1. The elements of an insurable risk are (1) a large number of homogeneous exposure units (2) the loss produced must be definite (3) the loss should be fortuitous (4) the loss should not be catastrophic—i.e., it should be unlikely that all exposure units will suffer loss at the same time. See pages 42-43. 2. The dual application of the law of large numbers requires a large enough sample for the insurer to make a good estimate of the probability, and a sufficient number of exposure units insured to permit the probability to work itself out. Inherent in this concept is the idea that there must be many exposures that do not suffer loss who make contributions to pay for the losses of the few who do. See page 40. - 22 -

  16. Page 16
    Read page 16 as text

    3. An increase in the number of observations in a sampling technique has no effect on the underlying probability of the event. It should, however, increase the accuracy of our estimate of the probability. As the number of exposures in the sample is increased, the standard deviation will decrease, reflecting the increased confidence in our estimate of the probability. 4. The two fundamental functions involved in the operation of the insurance mechanism are the transfer of the risk from the individual to the insurer or the group, and the sharing of losses on some equitable basis. These functions reduce or eliminate uncertainty for the individual, and provide a basis for spreading the impact of losses. As noted in the text (page 41), the essential feature of insurance is risk transfer. Pooling is an important technique available to the transferee, but it is not a requisite, and insurance transactions can occur in which the risk that is transferred is unique, and in which there is no pooling. Although insurance generally involves the reduction of risk in the aggregate, which is achieved by pooling, insurance transactions need not involve pooling. 5. In the case of the individual, insurance substitutes certainty for uncertainty by the substitution of the small certain cost (premium) for the large uncertain loss that would exist in the absence of the insurance. The uncertainty regarding whether or not a loss will occur is not diminished, but uncertainty regarding financial loss is eliminated for the individual. 6. Examples of uninsurable risks might include war (catastrophe), damage caused by termites (not definite in time), and speculative risks (insurance would be self-defeating by reducing or eliminating the potential gain). What is important in this question is why the risks are uninsurable. Generally, it will be because the risk does not meet one of the desirable elements of an insurable risk. 7. There are two costs to society that result from the existence of insurance. The first is the amount of loss that is caused by the existence of insurance. To the extent that individuals intentionally cause losses so they may collect under an insurance policy, society suffers losses that would not occur in the absence of insurance. The second cost of insurance to society is the cost of operating the insurance industry. The resources devoted to the operation of insurance companies and ancillary insurance-related services consume resources. The chief contributions of insurance are in reducing uncertainty regarding the impact of financial loss and the function of spreading the losses that do occur. By reducing uncertainty and providing a mechanism for the sharing of losses, insurance brings peace of mind to the members of society and makes costs more certain. In addition, it provides for more optimal utilization of capital. See pages 41- 42. 8. The specific conditions of a social insurance plan that distinguish it from private or voluntary insurance are those specified in the definition of social insurance proposed by the Commission on Terminology of the American Risk and Insurance Association. There are eight conditions listed on page 48 of the text. The most important of these, in our opinion, are the lack of equity and the compulsory nature. 9. The three general categories into which private insurance may be divided are life insurance, health insurance, and property and liability insurance. - 23 -

391 more pages in the full document

Unlock it once and it stays in your library, ready to chat with or turn into flashcards.

Unlock the full document

More Finance study materials

See all

Study this document with CramX

Once it is in your library, every tool can work from it.