Risk Management Final

Front 1

Ee Benefits: Why a Risk Mgmt Issue?

Back 1

Risky

Front 2

Ee Benefits: Why do Employers Provide?

Back 2

Taxes, Cost saving with group insurance – loadings for admin cost lower for a group, Competition for good employees, productivity effects/retention, regulation.

Front 3

Ee Benefits: Why Important?

Back 3

Benefits increase productivity, improve worker health, reduce turnover, reduce adverse selection, high cost, risky

Front 4

Taxes – Important Driver

Back 4

qualified plan – preferential tax treatment, for employer – same as cash wages (tax deductible), for employee – benefits not subject to income tax

Front 5

Why Group basis of Health Insurance makes sense

Back 5

employer provides coverage, employees choose service provider (lot of discretion), provider charges fee to employee or insurer, no contract with provider.

Front 6

Insurance products

Back 6

Indemnity, PPO, HMO, POS (all contain basic copays, dedcuctibles, coinsurance, out of pocket maximums, and lifetime maximums)

Front 7

HMO

Back 7

Reduces excessive utilization with contracts between providers and insurers, Employees choice of provider is restricted (choose PCP),

Front 8

Healthcare Inflation & Excessive Utilitzation

Back 8

ex ante moral hazard – incentive to take care reduced (group insurance), ex post – once sick, incentive for excessive coverage

Front 9

Reducing excess utilization

Back 9

increase deductibles and coinsurance, managed care ( insurer monitor use, limit choice in service providers), preferred provider organizations.

Front 10

Uninsureds

Back 10

About 14% of people (mostly short term), perception that cost is too high, unhealthy have trouble finding acceptance, other sources of coverage.

Front 11

Nationalization

Back 11

Gov’t specifies for all: insurance coverage, quality of care, expenditure – little or no support in US

Front 12

Universal Insurance

Back 12

mandatory employer provision, pay or play, would reduce uninsured, cost shifting from uninsured to insured, inefficient provision of service – worker wages would decrease and moral hazard would increase.

Front 13

Changes in Tax Law

Back 13

Lower tax benefit for employer provided insurance, reduce insurance coverage, MSAs – insurance for large medical expenses while MSA pays for small expenses less than $3000, MSA receives preferential tax treatment

Front 14

What are loss reserves?

Back 14

Unearned Premium Reserves – Held until unexpired policies are fully earned or cancelled. ◦ Loss and Loss Adjustment Expenses Reserves – Liabilities for claims from accidents that have occurred but are not yet settled.

Front 15

Why are loss reserves are so important to insurers?

Back 15

Financial statements depends on the accuracy of loss reserves. Pricing risk depends is on the accurate measurement of loss reserves. Measures of current profitability depends on maintaining adequate loss reserve liabilities. The size of loss reserves is about half the size of P/C Insurers assets or the largest liability on an insurance company balance sheet.

Front 16

What makes loss reserves such a technical difficulty?

Back 16

Calculated as expected value of future payments for claims currently in the course of settlement. Impossible to predict with certainty. estimates for individual claims will almost certainly be wrong. Patterns of claim submission often can change (e.g., with Progressive claim vans example). Includes loss adjustment expenses.

Front 17

How are loss reserves related to the agency issue that we discussed previously?

Back 17

Jobs and bonuses can depend on current profitability performance. ◦ Current managers are not compensated for future profitability. ◦ Changing the level of reserves can drastically alter the measure of current profitability.

Front 18

Why are loss reserves regulated?

Back 18

Policyholders pay for service in advance and depend on the promises of insurers to pay their claims. Insurers without adequate loss reserves are vulnerable to bankruptcy. Regulators monitor reserving to balance the manager’s agency issue and protect policyholders.

Front 19

What are some of loss reserves’ components?

Back 19

Case reserves, INBR, LAE reserves, loss triangles, paid claims, link ratios, loss development factors

Front 20

Why are Captives used?

Back 20

Find Insurance - Limited capacity. Take more risk, Pool risk, Control service providers claims, risk control, captive managers, etc. Access reinsurance markets• Customize coverages •Potential tax benefits, Wealth transfer and protection

Front 21

Basis Risk

Back 21

Basis risk refers to the uncertainty in the relationship between the variable being hedged and the derivative contract payoff being used to hedge

Front 22

Derivatives vs. Insurance

Back 22

Influence firm has on: derivative payoffs – little to none, insurance payoffs – possibly through loss control activities (greater moral hazard, more investigation and monitoring, retention). Derivative markets are generally more liquid. See slides for more

Front 23

Liquid Market

Back 23

someone can sell or buy an asset quickly with little price concession (factors include moral hazard and need to monitor credit worthiness of counter party).

Front 24

What are the major commercial P&C products?

Back 24

Property damage and loss of income, liability and related, multiple peril contracts, surety bonds and financial guarantees.

Front 25

Types of losses covered under a commercial property policy

Back 25

Property – commercial property and income, commercial liability, auto, crime, boiler and machinery, inland marine. Commercial Liability – auto, employer and workers comp, medical, professional liability and related, “General”

Front 26

What is occurrence coverage and how does it handle claims that occur over time?

Back 26

Policy in force when injury occurs must defend and indemnify, regardless of when claim made continuous and repeated exposure to the same general harmful conditions. BI or PD must occur during policy period. Coverage is not limited to sudden injuries, gradual injuries are covered unless otherwise excluded

Front 27

What are the benefits of increased retention?

Back 27

Save on premium loadings and transaction costs, Avoid implicit taxes due to insurance price Regulation, Reduce exposure to insurance market volatility, Reduce moral hazard, Avoid high premiums caused by asymmetric info

Front 28

What are the costs of increased retention?

Back 28

Ownership structure, firm size, correlation of losses, investment opportunities, product characteristics, correlation of losses with other cash flows, correlation of losses with investment opportunities, financial leverage

Front 29

What is a basic guideline for optimal retention?

Back 29

Retain reasonably predictable loss exposures and reduce risk of potentially large, disruptive loss exposures. Not always applicable (British petroleum)

Front 30

What is the aggregated vs dis-aggregated approach to risk management?

Back 30

Even if a firm wants to hedge some aggregate performance measure (e.g., earnings), it can do so by hedging all the individual sources of risk that influence earnings.

Front 31

Transaction costs (agg and disagg)

Back 31

Aggregated approach Bundle multiple risk exposures into one contract. Disaggregated approach hedge/insure each exposure with a separate contract.• 1st point: if there are fixed costs per contract, then is aggregated approach might be more costly• 2nd point: disaggregated approach will result in unnecessary coverage, which increases costs that are proportional to the amount of coverage• 3rd point: disagregated approach is more complex, which can make it more costly to supply

Front 32

Unnecessary Coverage

Back 32

Two Exposures ($20 million each) Example: Option 1: Purchase coverage on each loss with a deductible of $20 million. Option 2: Purchase coverage on total loss with a deductible of $40 million

Front 33

Complexity Problem

Back 33

Pricing a policy that covers multiple sources of risk is more complex it requires expertise in a variety of fields. It requires knowledge of correlation across loss exposures. It requires modeling skills. Implications: Administrative costs might be higher, There will be fewer suppliers and less competition (potentially higher costs).

Front 34

Corporate insurance purchases affect expected cash flows

Back 34

Premium Loadings decrease CFs, Services provided MAY increase CFs, Reduction in likelihood of raising new capital can increase CFs, Reduction in likelihood of financial distress can increase CFs, Reduction in expected tax payments can increase CFs.