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Questions Of Risk Management And Insurance

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George E. Rejda

Michael J. McNamara

Principles of Risk ManageMent and Insurance

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Library of Congress Cataloging-in-Publication Data Names: Rejda, George E. | McNamara, Michael J. Title: Principles of risk management and insurance / George E. Rejda, Michael J. McNamara. Description: Thirteenth Edition. | Hoboken : Pearson Education, Inc., 2016. | Revised edition of the authors’ Principles of risk management and insurance, 2014. Identifiers: LCCN 2015040965 | ISBN 9780134082578 Subjects: LCSH: Insurance. | Risk (Insurance) | Risk management. Classification: LCC HG8051.R44 2016 | DDC 368--dc23 LC record available at http://lccn.loc.gov/2015040965

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v

contents

Preface xv

PaRT onE Basic concePts in risk ManageMent and insurance

chaPter 1 risk and its treatMent 1 Definitions of Risk 2 Chance of Loss 4 Peril and Hazard 4 Classification of Risk 5 Major Personal Risks and Commercial Risks 7 Burden of Risk on Society 13 Techniques for Managing Risk 13 Summary 17 ■ Key Concepts and Terms 18 ■ Review Questions 18 ■ Application Questions 18 ■ Internet Resources 19 ■ Selected References 20 ■ Notes 20

Case Application 16 Insight 1.1: What Are Your Chances of Not Being Able to Earn an Income? Calculate Your

personal Disability Quotient 10

chaPter 2 insurance and risk 21 Definition of Insurance 22 Basic Characteristics of Insurance 22 Characteristics of an Ideally Insurable Risk 24 Two Applications: The Risks of Fire and Unemployment 26 Adverse Selection and Insurance 28 Insurance and Gambling Compared 28 Insurance and Hedging Compared 28 Types of Insurance 29 Benefits of Insurance to Society 33 Costs of Insurance to Society 34 Summary 38 ■ Key Concepts and Terms 39 ■ Review Questions 39 ■ Application Questions 39 ■ Internet Resources 40 ■ Selected References 40 ■ Notes 41

Case Application 38 Insight 2.1: Insurance Fraud Hall of Shame—Shocking Examples of Insurance Fraud 35

Insight 2.2: Have You Ever Committed Insurance Fraud? Think Again 37

Appendix: Basic Statistics and the Law of Large Numbers 42

chaPter 3 introduction to risk ManageMent 46 Meaning of Risk Management 48 Objectives of Risk Management 48 Steps in the Risk Management Process 48

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Benefits of Risk Management 59 Personal Risk Management 59 Summary 62 ■ Key Concepts and Terms 63 ■ Review Questions 63 ■ Application Questions 63 ■ Internet Resources 64 ■ Selected References 65 ■ Notes 65

Case Application 61 Insight 3.1: vermont Leads U.S. Captive Domiciles 53

Insight 3.2: Advantages of Self-Insurance 54

chaPter 4 enterPrise risk ManageMent and related toPics 67 Enterprise Risk Management 68 Insurance Market Dynamics 74 Loss Forecasting 80 Financial Analysis in Risk Management Decision Making 82 Other Risk Management Tools 84 Summary 87 ■ Key Concepts and Terms 87 ■ Review Questions 88 ■ Application Questions 88 ■ Internet Resources 88 ■ Selected References 89 ■ Notes 89

Case Application 86 Insight 4.1: Weather Futures and Options: Financial Tools That provide a Means of

Transferring Risk Associated with Adverse Weather Events 79

PaRT Two the Private insurance industry

chaPter 5 tyPes of insurers and Marketing systeMs 91 Overview of Private Insurance in the Financial Services Industry 92 Types of Private Insurers 93 Agents and Brokers 98 Types of Marketing Systems 99 Group Insurance Marketing 102 Summary 103 ■ Key Concepts and Terms 103 ■ Review Questions 104 ■ Application Questions 104 ■ Internet Resources 105 ■ Selected References 106 ■ Notes 106

Case Application 103 Insight 5.1: Show Me the Money—How Much Can I Earn as an Insurance Sales Agent? 99

chaPter 6 insurance coMPany oPerations 107 Insurance Company Operations 108 Rating and Rate Making 108 Underwriting 109 Production 112 Claims Settlement 113 Reinsurance 115 Investments 120 Other Insurance Company Functions 122 Summary 124 ■ Key Concepts and Terms 124 ■ Review Questions 125 ■ Application Questions 125 ■ Internet Resources 126 ■ Selected References 126 ■ Notes 127

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Case Application 123 Insight 6.1: Home Owner’s Failure to Cooperate Yields Denied Claim 115

Insight 6.2: Be a Smart Consumer—Check the Claims Record of Insurers before You Buy 116

chaPter 7 financial oPerations of insurers 128 Property and Casualty Insurers 129 Life Insurance Companies 134 Rate Making in Property and Casualty Insurance 136 Rate Making in Life Insurance 140 Summary 141 ■ Key Concepts and Terms 142 ■ Review Questions 142 ■ Application Questions 143 ■ Internet Resources 144 ■ Selected References 144 ■ Notes 144

Case Application 141 Insight 7.1: How profitable Is the property and Casualty Insurance Industry? 135

chaPter 8 governMent regulation of insurance 146 Reasons for Insurance Regulation 147 Historical Development of Insurance Regulation 148 Methods for Regulating Insurers 150 What Areas Are Regulated? 150 State versus Federal Regulation 156 Current Issues in Insurance Regulation 159 Modernizing Insurance Regulation 159 Insolvency of Insurers 162 Market Conduct Regulation 163 Summary 166 ■ Key Concepts and Terms 167 ■ Review Questions 167 ■ Application Questions 167 ■ Internet Resources 168 ■ Selected References 168 ■ Notes 169

Case Application 165 Insight 8.1: The pros and Cons of Credit-Based Insurance Scores 164

PaRT ThREE legal PrinciPles in risk and insurance

chaPter 9 fundaMental legal PrinciPles 170 Principle of Indemnity 171 Principle of Insurable Interest 174 Principle of Subrogation 175 Principle of Utmost Good Faith 176 Requirements of an Insurance Contract 179 Distinct Legal Characteristics of Insurance Contracts 180 Law and the Insurance Agent 181 Summary 184 ■ Key Concepts and Terms 185 ■ Review Questions 185 ■ Application Questions 185 ■ Internet Resources 186 ■ Selected References 186 ■ Notes 186

Case Application 183 Insight 9.1: Corporation Lacking Insurable Interest at Time of Death Can Receive Life

Insurance proceeds 176

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Insight 9.2: Auto Insurer Denies Coverage Because of Material Misrepresentation 177

Insight 9.3: Insurer voids Coverage Because of Misrepresentations in proof of Loss 178

chaPter 10 analysis of insurance contracts 188 Basic Parts of an Insurance Contract 189 Definition of “Insured” 191 Endorsements and Riders 193 Deductibles 193 Coinsurance 195 Coinsurance in Health Insurance 196 Other-Insurance Provisions 196 Summary 199 ■ Key Concepts and Terms 199 ■ Review Questions 200 ■ Application Questions 200 ■ Internet Resources 201 ■ Selected References 201 ■ Notes 201

Case Application 198 Insight 10.1: When You Drive Your Roommate’s Car, Are You Covered Under Your

policy? 192

PaRT FouR life and health risks

chaPter 11 life Insurance 202 Premature Death 203 Financial Impact of Premature Death on Different Types of Families 204 Amount of Life Insurance to Own 205 Types of Life Insurance 210 Variations of Whole Life Insurance 216 Other Types of Life Insurance 224 Summary 228 ■ Key Concepts and Terms 229 ■ Review Questions 230 ■ Application Questions 230 ■ Internet Resources 232 ■ Selected References 233 ■ Notes 233

Case Application 227 Insight 11.1: Cash-value Life Insurance as an Investment—Don’t Ignore Two points 215

Insight 11.2: Be a Savvy Consumer—Four Life Insurance policies to Avoid 226

chaPter 12 life insurance contractual Provisions 234 Life Insurance Contractual Provisions 235 Dividend Options 241 Nonforfeiture Options 243 Settlement Options 245 Additional Life Insurance Benefits 249 Summary 254 ■ Key Concepts and Terms 255 ■ Review Questions 256 ■ Application Questions 256 ■ Internet Resources 257 ■ Selected References 258 ■ Notes 258

Case Application 254 Insight 12.1: Is This Death A Suicide? 237

Insight 12.2: Selection of the Best Dividend Option in a participating Whole Life policy 242

Insight 12.3: Accelerated Death Benefits—A Real-Life Example 252

Insight 12.4: What Is a Life Settlement? Examples of Actual Cases 253

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chaPter 13 Buying life insurance 259 Determining the Cost of Life Insurance 260 Rate of Return on Saving Component 263 Taxation of Life Insurance 265 Shopping for Life Insurance 267 Summary 270 ■ Key Concepts and Terms 270 ■ Review Questions 270 ■ Application Questions 271 ■ Internet Resources 271 ■ Selected References 272 ■ Notes 272

Case Application 269 Insight 13.1: Be Careful in Replacing an Existing Life Insurance policy 263

Appendix: Calculation of Life Insurance Premiums 273

chaPter 14 annuities and individual retireMent accounts 278 Individual Annuities 279 Types of Annuities 280 Taxation of Individual Annuities 287 Individual Retirement Accounts 288 Adequacy of IRA Funds 291 Summary 294 ■ Key Concepts and Terms 295 ■ Review Questions 295 ■ Application Questions 296 ■ Internet Resources 296 ■ Selected References 297 ■ Notes 297

Case Application 1 293

Case Application 2 294 Insight 14.1: Advantages of an Immediate Annuity to Retired Workers 281

Insight 14.2: Bells and Whistles of variable Annuities 284

Insight 14.3: Ten Questions to Answer Before You Buy a variable Annuity 288

Insight 14.4: Will You Have Enough Money at Retirement? Monte Carlo Simulations Can Be Helpful 292

chaPter 15 healthcare reforM: individual health insurance coverages 298 Defects in the Healthcare System in the United States 299 Basic Provisions of the Affordable Care Act 304 Individual Medical Expense Insurance 310 Individual Medical Expense Plans and Managed Care 312 Health Savings Accounts 313 Long-Term Care Insurance 314 Disability-Income Insurance 318 Individual Health Insurance Contractual Provisions 321 Summary 323 ■ Key Concepts and Terms 324 ■ Review Questions 324 ■ Application Questions 325 ■ Internet Resources 325 ■ Selected References 326 ■ Notes 327

Case Application 323 Insight 15.1: Health Insurance Options for College Students under the Affordable

Care Act 307

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chaPter 16 eMPloyee Benefits: grouP life and health insurance 328 Meaning of Employee Benefits 329 Fundamentals of Group Insurance 329 Group Life Insurance 331 Group Medical Expense Insurance 332 Managed Care Plans 334 Affordable Care Act and Group Medical Expense Insurance 336 Key Features of Group Medical Expense Insurance 338 Consumer-Directed Health Plans 339 Recent Developments in Employer-Sponsored Health Plans 340 Group Medical Expense Contractual Provisions 343 Group Dental Insurance 344 Group Disability-Income Insurance 345 Cafeteria Plans 346 Summary 348 ■ Key Concepts and Terms 349 ■ Review Questions 349 ■ Application Questions 350 ■ Internet Resources 351 ■ Selected References 351 ■ Notes 351

Case Application 347 Insight 16.1: Basic Characteristics of the Small Business Health Options (SHOp) Marketplace

program 338

chaPter 17 eMPloyee Benefits: retireMent Plans 353 Fundamentals of Private Retirement Plans 354 Types of Qualified Retirement Plans 357 Defined-Benefit Plans 357 Defined-Contribution Plans 360 Section 401(K) Plan 361 Section 403(B) Plan 363 Profit-Sharing Plans 364 Retirement Plans for the Self-Employed (Keogh Plans) 364 Simplified Employee Pension (SEP) 364 Simple IRA Plan 365 Saver’s Credit 365 Funding Agency and Funding Instruments 366 Problems and Issues in Tax-Deferred Retirement Plans 367 Summary 369 ■ Key Concepts and Terms 370 ■ Review Questions 370 ■ Application Questions 370 ■ Internet Resources 371 ■ Selected References 371 ■ Notes 372

Case Application 368 Insight 17.1: Six Common 401 (k) Mistakes 362

chaPter 18 social insurance 373 Social Insurance 374 Old-Age, Survivors, and Disability Insurance 376 Types of Benefits 377 Medicare 383 Problems and Issues 388 Unemployment Insurance 391 Workers Compensation 393

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Summary 398 ■ Key Concepts and Terms 398 ■ Review Questions 399 ■ Application Questions 399 ■ Internet Resources 400 ■ Selected References 401 ■ Notes 402

Case Application 397 Insight 18.1: Claiming Social Security Benefits — Strategies for Single persons 380

Insight 18.2: How Would You Reduce the Long-Range Social Security Deficit? 389

PaRT FIvE Personal ProPerty and liaBility risks

chaPter 19 the liaBility risk 403 Basis of Legal Liability 404 Law of Negligence 405 Imputed Negligence 407 Res Ipsa Loquitur 408 Specific Applications of the Law of Negligence 408 Current Tort Liability Problems 410 Summary 420 ■ Key Concepts and Terms 420 ■ Review Questions 421 ■ Application Questions 421 ■ Internet Resources 422 ■ Selected References 423 ■ Notes 423

Case Application 419 Insight 19.1: Judicial Hellholes 2014–2015 413

chaPter 20 auto insurance 425 Overview of Personal Auto Policy 426 Part A: Liability Coverage 427 Part B: Medical Payments Coverage 433 Part C: Uninsured Motorists Coverage 434 Part D: Coverage for Damage to Your Auto 438 Part E: Duties after an Accident or Loss 445 Part F: General Provisions 446 Insuring Motorcycles and Other Vehicles 447 Summary 448 ■ Key Concepts and Terms 448 ■ Review Questions 448 ■ Application Questions 449 ■ Internet Resources 451 ■ Selected References 451 ■ Notes 451

Case Application 447 Insight 20.1: What Do Ride Sharing and Car Sharing Mean for personal Auto

Insurance? 430

Insight 20.2: New Study Reveals a Declining Trend in the percentage of Uninsured Motorists 435

Insight 20.3: Using Electronic Devices while Driving Is a Serious problem 442

chaPter 21 auto insurance (Continued) 453 Approaches for Compensating Auto Accident Victims 454 Auto Insurance for High-Risk Drivers 464 Cost of Auto Insurance 465 Shopping for Auto Insurance 469 Summary 473 ■ Key Concepts and Terms 473 ■ Review Questions 474 ■ Application Questions 474 ■ Internet Resources 474 ■ Selected References 475 ■ Notes 475

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Case Application 472 Insight 21.1: Filing an Auto Claim with the Other party’s Insurance Company 458

Insight 21.2: protect Yourself: Insuring Your Teen Driver 468

Insight 21.3: More Folks Are Tweeting, Texting, and Taking pictures While Driving: AT&T Survey 471

chaPter 22 hoMeowners insurance, section i 477 Homeowners Insurance 478 Analysis of Homeowners 3 Policy (Special Form) 482 Section I Coverages 483 Section I Perils Insured Against 489 Section I Exclusions 492 Section I Conditions 493 Section I and II Conditions 498 Summary 500 ■ Key Concepts and Terms 500 ■ Review Questions 500 ■ Application Questions 501 ■ Internet Resources 502 ■ Selected References 503 ■ Notes 503

Case Application 499 Insight 22.1: Renters Insurance Checklist 481

Insight 22.2: How Do I Take a Home Inventory and Why? 494

Insight 22.3: The Big Gap between Replacement Cost and Actual Cash value Can Empty Your Wallet 495

chaPter 23 hoMeowners insurance, section ii 504 Personal Liability Insurance 505 Section II Exclusions 507 Section II Additional Coverages 511 Section II Conditions 512 Endorsements to a Homeowners Policy 513 Cost of Homeowners Insurance 516 Summary 520 ■ Key Concepts and Terms 521 ■ Review Questions 521 ■ Application Questions 522 ■ Internet Resources 523 ■ Selected References 523 ■ Notes 523

Case Application 520 Insight 23.1: Dog Bites Hurt, So Do Lawsuits 506

Insight 23.2: Trying to Save Money? Avoid the Five Biggest Insurance Mistakes! 519

chaPter 24 other ProPerty and liaBility insurance coverages 525 ISO Dwelling Program 526 Mobile Home Insurance 528 Inland Marine Floaters 529 Watercraft Insurance 530 Government Property Insurance Programs 531 Title Insurance 536 Personal Umbrella Policy 539

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Summary 543 ■ Key Concepts and Terms 543 ■ Review Questions 544 ■ Application Questions 544 ■ Internet Resources 545 ■ Selected References 546 ■ Notes 546

Case Application 542 Insight 24.1: Dispelling Myths about Flood Insurance 535

Insight 24.2: Title Insurance: protecting Your Home Investment against Unknown Title Defects 537

Insight 24.3: Umbrella Insurance policies: Why You Might Want That Extra protection 540

PaRT SIx coMMercial ProPerty and liaBility risks

chaPter 25 coMMercial ProPerty insurance 548 Commercial Package Policy 549 Building and Personal Property Coverage Form 551 Causes-of-Loss Forms 554 Endorsements 554 Reporting Forms 556 Business Income Insurance 557 Other Commercial Property Coverages 560 Transportation Insurance 563 Businessowners Policy (BOP) 568 Summary 570 ■ Key Concepts and Terms 571 ■ Review Questions 571 ■ Application Questions 572 ■ Internet Resources 573 ■ Selected References 574 ■ Notes 574

Case Application 569 Insight 25.1: Three Commercial property Endorsements That Every Client Should Have 555

Insight 25.2: Examples of Equipment Breakdown Claims: Recent paid Claims 562

chaPter 26 coMMercial liaBility insurance 576 General Liability Loss Exposures 577 Commercial General Liability Policy 578 Employment-Related Practices Liability Insurance 586 Workers Compensation Insurance 587 Commercial Auto Insurance 589 Aircraft Insurance 591 Commercial Umbrella Policy 593 Cyber Liability Insurance 594 Businessowners Policy 595 Professional Liability Insurance 595 Directors and Officers Liability Insurance 597 Summary 599 ■ Key Concepts and Terms 600 ■ Review Questions 600 ■ Application Questions 601 ■ Internet Resources 602 ■ Selected References 602 ■ Notes 602

Case Application 598 Insight 26.1: Cyber Loss Exposure—No Longer Breaching the CGL 581

Insight 26.2: Basic Facts about Workers Compensation 588

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chaPter 27 criMe insurance and surety Bonds 605 The ISO Commercial Crime Insurance Program 606 Commercial Crime Coverage Form (Loss-Sustained Form) 607 Financial Institution Bonds 612 Surety Bonds 613 Summary 616 ■ Key Concepts and Terms 617 ■ Review Questions 617 ■ Application Questions 617 ■ Internet Resources 618 ■ Selected References 619 ■ Notes 619

Case Application 615 Insight 27.1: Crime prevention Tips for Small Businesses 609

appendix a: Personal auto Policy 620

appendix B: homeowners 3 (Special Form) 634

Glossary 659

Index 678

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This text deals with risk and its management. Since the last edition of the text appeared, several trage- dies have occurred that clearly demonstrate the deadly presence of risk in our society. A suicide bomber entered a market near Baghdad, detonated a bomb, and killed 11 people. Malaysia Flight 360 mysteri- ously disappeared with 239 passengers aboard, caus- ing an enormous amount of pain and suffering to the surviving families. A deadly earthquake struck Nepal, a low-income country in Asia, which killed more than 8,600 people and destroyed or damaged tens of thou- sands of houses. Meanwhile, in the United States, a gunman killed nine members of a Bible study group in an historical African American church in Charleston, South Carolina, and a student enrolled at Umpqua Community College in Oregon killed nine people and himself in a tragic and senseless shooting.

In addition to reporting events making national headlines, the media routinely report on tragic events at the local level that clearly show the destructive presence of risk. A runner is hit by a car while jogging; a tornado touches down and destroys most of a small town; a house fire leaves a family homeless; a drunk driver fails to stop at a red light and smashes into another motorist; a plant explosion kills two people and injures several employees; and a blinding snowstorm and ice-packed interstate highway cause a chain-like accident and collision damage to 10 cars. To say that we live in a risky and dangerous world is an enormous understatement.

This thirteenth edition of Principles of Risk Man- agement and Insurance discusses these issues and other insurance issues as well. As in previous editions, the text is designed for a beginning undergraduate course in risk management and insurance with no pre- requisites. This edition provides an in-depth treatment of major risk management and insurance topics. Top- ics discussed include basic concepts of risk and insur- ance, introductory and advanced topics in traditional risk management and enterprise risk management,

functional and financial operations of insurers, legal principles, life and health insurance, property and liability insurance, employee benefits, and social insurance. In addition, the Affordable Care Act is dis- cussed in depth. Once again, Principles of Risk Management and Insurance places primary emphasis on insurance consumers and blends basic risk man- agement and insurance principles with consumer considerations. With this user-friendly text, students can apply basic concepts immediately to their own personal risk management and insurance programs.

kEY ConTEnT ChanGES In ThE ThIRTEEnTh EDITIon Thoroughly revised and updated, this edition pro- vides an in-depth analysis of current insurance indus- try issues and practices, which readers have come to expect from Principles of Risk Management and Insurance. Key content changes in this edition include the following:

• Capital retention approach eliminated. In Chapter 11, the capital retention approach for determining the amount of life insurance has been eliminated. This method generally is not discussed in the online websites of life insur- ers. In contrast, the needs approach is heavily stressed in the available online calculators.

• Healthcare reform. Chapter 15 has an in-depth discussion and update of the broken healthcare delivery system in the United States, which led to enactment of the Affordable Care Act.

• Update on the Affordable Care Act. Chapters 15 and 16 provide an update on the Affordable Care Act (ACA) and its impact on individual and group health insurance coverages. Primary attention is devoted to provisions that have a major financial impact on individuals, families, and employers. Chapter 18 summarizes the possible desirable and

Preface

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undesirable effects of the ACA on both workers compensation programs and employers.

• Current developments in employer-sponsored group health insurance plans. Employers con- tinue to grapple with the rapid increase in group health insurance premiums and to seek new so- lutions for holding down costs. Chapter 16 dis- cusses current trends in group health insurance to contain higher healthcare costs and premiums.

• Change in sequence of homeowners and auto insurance chapters. In previous editions, home- owners insurance was discussed prior to auto insurance. This thirteenth edition reverses the se- quence of homeowners and auto insurance chap- ters. Auto insurance is discussed first because it is more relevant and interesting to students than homeowners insurance. In addition, discussion of liability coverage in the Personal Auto Policy (now Chapter 20) logically follows the general discussion of the liability risk treated in the previ- ous chapter (Chapter 19).

• Legalization of medical marijuana and opiate overuse in workers compensation. The medical use of marijuana has been legalized in at least 20 states and the District of Columbia. The increased use of medical marijuana and opiate overuse, and their impact on workers compensation programs, are important issues discussed in Chapter 18.

• Cyber-liability insurance. Computer hackers have been successful in accessing the credit card records and other personal information of millions of cus- tomers of major retail firms. Cyber-liability insur- ance covers damages arising from the failure of a data holder to protect private information from being accessed by an unauthorized party. Chapter 26 discusses some basic concepts in cyber-liability insurance.

• New Insurance Services Office (ISO) Forms. The latest revisions of the ISO Commercial Property form, the Commercial General Liability form, and the Commercial/Government Crime Forms are discussed in these pages. The text also covers the new Auto Dealers Coverage form.

• New Insight boxes. A number of new and timely Insight boxes appear. Insights are valuable learn- ing tools that provide real-world applications of a concept or principle discussed in the text.

• Technical accuracy. As in previous editions, numerous experts have reviewed the text for

technical accuracy, especially in areas where changes occur rapidly. This new edition presents technically accurate and up-to-date material.

InSTRuCToR RESouRCES At the Instructor Resource Center, www.pearsonhigh- ered.com/irc, instructors can easily register to gain access to a variety of instructor resources available with this text in downloadable format. If assistance is needed, our dedicated technical support team is ready to help with the media supplements that accompany this text. Visit http://247.pearsoned.com for answers to frequently asked questions and toll-free user sup- port phone numbers.

The following supplements are available with this text:

• Companion Website – Internet exercises – A multiple choice practice quiz for each chapter

• Instructor’s Resource Manual & Test Bank • TestGen® Computerized Test Bank • PowerPoint Presentations • Student Study Guide

aCKnowLEDGMEnTS A market-leading text is never written alone. We owe an enormous intellectual debt to numerous risk man- agement and insurance professors, risk management experts, insurance industry personnel, and other professionals for their kind and gracious assistance. These experts provided supplementary materials, made valuable comments, answered technical ques- tions, or provided other help. As a result, this new edition is a substantially improved educational prod- uct. Our experts include the following:

• Steve Avila, Ball State University • Burton T. Beam, Jr., The American College (retired) • Patricia Born, Florida State University • Nick Brown, Chief Executive Officer, Global Aerospace

• Leon Chen, Minnesota State University, Mankato • Ann Costello, University of Hartford • Edward Graves, The American College (retired) • Jane Henderson, LIMRA • Robert Klein, Georgia State University

A01_REJD2578_13_SE_FM.indd 16 12/17/15 3:47 AM

http://www.pearsonhighered.com/irc
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P r E f a C E x v I I

• Yu-Luen Ma, Illinois State University • Rebecca A. McQuade, Director of Risk Manage- ment, PACCAR, Inc.

• William H. Rabel, The University of Alabama • Bill Rives, The Ohio State University • Fred Travis, University of Missouri-Columbia • Johnny Vestal, Texas Tech University • Eric Wiening, Insurance and Risk Management Author/Educator/Consultant

• Millicent W. Workman, Research Analyst, Inter- national Risk Management Institute, Inc. (IRMI), and Editor, Practical Risk Management

The views expressed in the text are those solely of the authors and do not necessarily reflect the viewpoints

or positions of the reviewers whose assistance we gratefully acknowledge.

Finally, the fundamental objective underlying this thirteenth edition remains the same as in the first edition: We have attempted to write an intellectually stimulating and visually attractive textbook from which students can learn and professors can teach.

George E. Rejda, Ph.D., CLU Emeritus Professor of Finance, University of

Nebraska—Lincoln

Michael J. McNamara, Ph.D., CPCU, CLU, ARM Mutual of Enumclaw/Field Distinguished Professor

of Insurance, Washington State University

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1

“When we take a risk, we are betting on an outcome that will result from a decision we have made, though we do not know for certain what the outcome will be.”

Peter L. Bernstein Against the Gods: The Remarkable Story of Risk

Risk and its tReatment1

After studying this chapter, you should be able to

■■ Explain the historical definition of risk.

■■ Explain the meaning of loss exposure.

■■ Understand the following types of risk:

– Pure risk

– Speculative risk

– Diversifiable risk

– Nondiversifiable risk

– Enterprise risk

– Systemic risk

■■ Identify the major pure risks that are associated with great economic insecurity.

■■ Show how risk is a burden to society.

■■ Explain the major techniques for managing risk.

Learning Object ives

Chapter

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Employees in the insurance industry often use the term risk in a different manner to identify the prop- erty or life that is being considered for insurance. For example, in the insurance industry, it is common to hear statements such as “That driver is a poor risk” or “That building is an unacceptable risk.”

Risk Distinguished from Uncertainty

In the economics and finance literature, authors and actuaries often make a distinction between risk and uncertainty. According to the American Academy of Actuaries, the term risk is used in situations where the probabilities of possible outcomes are known or can be estimated with some degree of accuracy, whereas uncertainty is used in situations where such probabili- ties cannot be estimated.1 For example, the probability

Definitions of risk There is no single definition of risk. Economists, behavioral scientists, risk theorists, statisticians, actu- aries, and historians each have their own concept of risk.

Traditional Definition of Risk

Risk traditionally has been defined in terms of uncer- tainty. Based on this concept, risk is defined as uncer- tainty concerning the occurrence of a loss. For example, the risk of being killed in an auto accident is present because uncertainty is present. The risk of lung cancer for smokers is present because uncertainty is present. The risk of flunking a required college course is present because uncertainty is present.

Jason, age 24, is a senior at a large Midwestern university. He has a part-time job as a cashier in a liquor store located near the university campus. Around mid- night, on a Saturday night, an intoxicated customer entered the store, grabbed a bot- tle of wine, and attempted to leave without paying. When Jason blocked his exit, the enraged customer pulled a knife and stabbed Jason repeatedly in the chest and neck, severing a major artery. Jason died while being transported to a local hospital.

Jason’s tragic and untimely death shows that we live in a risky, dangerous, and vio- lent world. The news media report daily on similar tragic events that clearly illustrate the widespread presence of a risk in our society. Examples abound—two terrorists armed with assault weapons stormed into the newsroom of a satirical magazine kill- ing 12 people; a drunk driver on a crowded expressway changed lanes suddenly and severely injured four people; a tornado touched down and wiped out a small town; a river overflows, and thousands of acres of farm crops are lost; and an executive is found guilty of defrauding his company of several millions of dollars. In addition, peo- ple often experience personal tragedies and financial setbacks that seldom make the news headlines but nevertheless cause great economic insecurity—the unexpected death of a family head; catastrophic medical bills that wipe out a family’s savings; the loss of a good-paying job and long-term unemployment during a severe business recession; and total disability from an accident of sickness that results in a significant loss of earnings.

This chapter discusses the nature and treatment of risk in our society. Topics dis- cussed include the meaning of risk, the major types of personal risks that affect indi- viduals and families, major commercial risks that affect business firms, the burden of risk on society, and the major methods for managing risk.

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from expected loss is only 100. Objective risk is now 100/10,000, or 1 percent. Thus, as the square root of the number of houses increased from 100 in the first example to 1,000 in the second example (10 times), objective risk declined to one-tenth of its former level.

Objective risk can be statistically calculated by some measure of dispersion, such as the standard deviation or the coefficient of variation. Because objective risk can be measured, it is an extremely use- ful concept for an insurer or a corporate risk manager. As the number of exposures increases, an insurer can predict its future loss experience more accurately because it can rely on the law of large numbers. The law of large numbers states that as the number of exposure units increases, the more closely the actual loss experience will approach the expected loss experi- ence. For example, as the number of homes under observation increases, the greater is the degree of accuracy in predicting the proportion of homes that will burn. The law of large numbers is discussed in greater detail in Chapter 2.

Subjective Risk (Perceived Risk)

Subjective risk (perceived risk) is defined as uncer- tainty based on a person’s mental condition or state of mind. Another name for subjective risk is perceived risk; some authors use the term in their discussion of the perception of risk by individuals. For example, assume that a driver with several convictions for drunk driving is drinking heavily in a neighborhood bar and foolishly attempts to drive home. The driver may be uncertain whether he will arrive home safely without being arrested by the police for drunk driv- ing. This mental uncertainty or perception is called subjective risk.

The impact of subjective risk varies depending on the individual. Two persons in the same situation can have a different perception of risk, and their behavior may be altered accordingly. If an individual experi- ences great mental uncertainty concerning the occur- rence of a loss, that person’s behavior may be affected. High subjective risk often results in conservative and prudent behavior, whereas low subjective risk may result in less conservative behavior. For example, assume that a motorist previously arrested for drunk driving is aware that he has consumed too much alco- hol. The driver may then compensate for the mental uncertainty by getting someone else to drive the car

of dying at each attained age can be estimated with considerable accuracy. In contrast, the probability of destruction of your home by a meteorite from outer space is only a guess and generally cannot be accurately estimated. As such, many authors have developed their own concept of risk, and numerous definitions of risk exist in the professional literature.2

Loss Exposure

Because risk is an ambiguous term and has different meanings, many authors and corporate risk managers use the term loss exposure to identify potential losses. A loss exposure is any situation or circumstance in which a loss is possible, regardless of whether a loss actually occurs. Examples of loss exposures include manufacturing plants that may be damaged by an earthquake or flood, defective products that may result in lawsuits against the manufacturer, possible theft of company property because of inadequate security, and potential injury to employees because of unsafe working conditions.

Finally, when the definition of risk includes the concept of uncertainty, some authors make a careful distinction between objective risk and subjective risk.

Objective Risk

Objective risk (also called degree of risk) is defined as the relative variation of actual loss from expected loss. For example, assume that a property insurer has 10,000 houses insured over a long period and, on average, 1 percent, or 100 houses, burn each year. However, it would be rare for exactly 100 houses to burn each year. In some years, as few as 90 houses may burn; in other years, as many as 110 houses may burn. Thus, there is a variation of 10 houses from the expected number of 100, or a variation of 10 percent. This relative variation of actual loss from expected loss is known as objective risk.

Objective risk declines as the number of expo- sures increases. More specifically, objective risk varies inversely with the square root of the number of cases under observation. In our previous example, 10,000 houses were insured, and objective risk was 10/100, or 10 percent. Now assume that 1 million houses are insured. The expected number of houses that will burn is now 10,000, but the variation of actual loss

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ambiguity in the way in which the probability is per- ceived. For example, assume that a slot machine in a casino requires a display of three lemons to win. The person playing the machine may perceive the proba- bility of winning to be quite high. But if there are 10 symbols on each reel and only one is a lemon, the objective probability of hitting the jackpot with three lemons is quite small. Assuming that each reel spins independently of the others, the probability that all three will simultaneously show a lemon is the product of their individual probabilities (1/10 * 1/10 * 1/10 = 1/1,000). This knowledge is advantageous to casino owners, who know that most gamblers are not trained statisticians and are therefore likely to overestimate the objective probabilities of winning.

Chance of Loss versus Objective Risk

Chance of loss can be distinguished from objective risk. Chance of loss is the probability that an event that causes a loss will occur. Objective risk is the rela- tive variation of actual loss from expected loss. The chance of loss may be identical for two different groups, but objective risk may be quite different. For example, assume that a property insurer has 10,000 homes insured in Los Angeles and 10,000 homes insured in Philadelphia and that the chance of a fire in each city is 1 percent. Thus, on average, 100 homes should burn annually in each city. However, if the annual variation in losses ranges from 75 to 125 in Philadelphia, but only from 90 to 110 in Los Angeles, objective risk is greater in Philadelphia even though the chance of loss in both cities is the same.

peril anD hazarD The terms peril and hazard should not be confused with the concept of risk discussed earlier.

Peril

Peril is defined as the cause of loss. If your house burns because of a fire, the peril, or cause of loss, is the fire. If your car is damaged in a collision with another car, collision is the peril, or cause of loss. Common perils that cause loss to property include fire, lightning, windstorm, hail, tornado, earthquake, flood, burglary, and theft.

home or by taking a cab. Another driver in the same situation may perceive the risk of being arrested as slight. This second driver might drive in a more care- less and reckless manner; a low subjective risk results in less conservative driving behavior.

ChanCe of loss Chance of loss is closely related to the concept of risk. Chance of loss is defined as the probability that an event will occur. Like risk, probability has both objec- tive and subjective aspects.

Objective Probability

Objective probability refers to the long-run relative frequency of an event based on the assumptions of an infinite number of observations and of no change in the underlying conditions. Objective probabilities can be determined in two ways. First, they can be deter- mined by deductive reasoning. These probabilities are called a priori probabilities. For example, the proba- bility of getting a head from the toss of a perfectly balanced coin is 1/2 because there are two sides, and only one is a head. Likewise, the probability of rolling a 6 with a single die is 1/6, since there are six sides and only one side has six dots.

Second, objective probabilities can be determined by inductive reasoning rather than by deduction. For example, the probability that a person age 21 will die before age 26 cannot be logically deduced. However, by a careful analysis of past mortality experience, life insurers can estimate the probability of death and sell a five-year term life insurance policy issued at age 21.

Subjective Probability

Subjective probability is the individual’s personal esti- mate of the chance of loss. Subjective probability need not coincide with objective probability. For example, people who buy a lottery ticket on their birthday may believe it is their lucky day and overestimate the small chance of winning. A wide variety of factors can influ- ence subjective probability, including a person’s age, gender, intelligence, education, and the use of alcohol or drugs.

In addition, a person’s estimate of a loss may dif- fer from objective probability because there may be

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chance of an accident. Careless acts like these increase the frequency and severity of loss.

The term morale hazard has the same meaning as attitudinal hazard. Morale hazard is a term that appeared in earlier editions of this text to describe someone who is careless or indifferent to a loss. How- ever, the term attitudinal hazard is more widely used today and is less confusing to students and more descriptive of the concept being discussed.

Legal Hazard Legal hazard refers to characteristics of the legal system or regulatory environment that increase the frequency or severity of losses. Examples include adverse jury verdicts or large damage awards in liability lawsuits; statutes that require insurers to include coverage for certain benefits in health insur- ance plans, such as coverage for alcoholism; and regu- latory action by state insurance departments that prevents insurers from withdrawing from a state because of poor underwriting results.

ClassifiCation of risk Risk can be classified into several distinct classes. The most important include the following:

■■ Pure and speculative risk ■■ Diversifiable risk and nondiversifiable risk ■■ Enterprise risk ■■ Systemic risk

Pure Risk and Speculative Risk

Pure risk is defined as a situation in which there are only the possibilities of loss or no loss. The only pos- sible outcomes are adverse (loss) and neutral (no loss). Examples of pure risks include premature death, job- related accidents, catastrophic medical expenses, and damage to property from fire, lightning, flood, or earthquake.

In contrast, speculative risk is defined as a situa- tion in which either profit or loss is possible. For example, if you purchase 100 shares of common stock, you would profit if the price of the stock increases but would lose if the price declines. Other examples of speculative risks include betting on a horse race, investing in real estate, and going into business for yourself. In these situations, both profit and loss are possible.

Hazard

A hazard is a condition that creates or increases the frequency or severity of loss. There are four major types of hazards:

■■ Physical hazard ■■ Moral hazard ■■ Attitudinal hazard (morale hazard) ■■ Legal hazard

Physical Hazard A physical hazard is a physical con- dition that increases the frequency or severity of loss. Examples of physical hazards include icy roads that increase the chance of an auto accident, defective wir- ing in a building that increases the chance of fire, and a defective lock on a door that increases the chance of theft.

Moral Hazard Moral hazard is dishonesty or char- acter defects in an individual that increase the fre- quency or severity of loss. Examples of moral hazard in insurance include faking an accident to collect ben- efits from an insurer, submitting a fraudulent claim, inflating the amount of a claim, and intentionally burning unsold merchandise that is insured. Murder- ing the insured to collect the life insurance proceeds is another important example of moral hazard.

Moral hazard is present in all forms of insurance, and it is difficult to control. Dishonest individuals often rationalize their actions on the grounds that “the insurer has plenty of money.” This view is incor- rect because the insurer can pay claims only by col- lecting premiums from other insureds. Because of moral hazard, insurance premiums are higher for everyone.

Insurers attempt to control moral hazard by the careful underwriting of applicants for insurance and by various policy provisions, such as deductibles, waiting periods, exclusions, and riders. These provi- sions are examined in Chapter 10.

Attitudinal Hazard (Morale Hazard) Attitudinal hazard is carelessness or indifference to a loss, which increases the frequency or severity of a loss. Examples of attitudinal hazard include leaving car keys in an unlocked car, which increases the chance of theft; leaving a door unlocked, which allows a burglar to enter; and changing lanes suddenly on a congested expressway without signaling, which increases the

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In contrast, nondiversifiable risk is a risk that affects the entire economy or large numbers of per- sons or groups within the economy. It is a risk that cannot be eliminated or reduced by diversification. Examples include rapid inflation, cyclical unemploy- ment, war, hurricanes, floods, and earthquakes because large numbers of individuals or groups are affected. Because nondiversifiable risk affects the entire economy or large numbers of persons in the economy, it is also called as fundamental risk.

The distinction between a diversifiable and non- diversifiable (fundamental) risk is important because government assistance may be necessary to insure nondiversifiable risks. Social insurance and govern- ment insurance programs, as well as government guarantees or subsidies, may be necessary to insure certain nondiversifiable risks in the United States. For example, the risks of widespread unemployment and flood are difficult to insure privately because the characteristics of an ideal insurable risk (discussed in Chapter 2) are not easily met. As a result, state unemployment compensation programs are neces- sary to provide weekly income to workers who become involuntarily unemployed. Likewise, the fed- eral flood insurance program makes property insur- ance available to individuals and business firms in flood zones.

Enterprise Risk

Enterprise risk is a term that encompasses all major risks faced by a business firm. Such risks include pure risk, speculative risk, strategic risk, operational risk, and financial risk. We have already explained the meaning of pure and speculative risk. Strategic risk refers to uncertainty regarding the firm’s financial goals and objectives; for example, if a firm enters a new line of business, the line may be unprofitable. Operational risk results from the firm’s business oper- ations. For example, a bank that offers online banking services may incur losses if “hackers” break into the bank’s computer.

Enterprise risk also includes financial risk, which is becoming more important in a commercial risk management program. Financial risk refers to the uncertainty of loss because of adverse changes in com- modity prices, interest rates, foreign exchange rates, and the value of money. For example, a food com- pany that agrees to deliver cereal at a fixed price to a

It is important to distinguish between pure and speculative risks for three reasons. First, private insur- ers generally concentrate on pure risks and do not emphasize the insurance of speculative risks. How- ever, there are exceptions. Some insurers will insure institutional portfolio investments and municipal bonds against loss. Also, enterprise risk management (discussed later) is another important exception where certain speculative risks can be insured.

Second, the law of large numbers can be applied more easily to pure risks than to speculative risks. The law of large numbers is important because it enables insurers to predict future loss experience. In contrast, it is generally more difficult to apply the law of large numbers to speculative risks to predict future loss experience. An exception is the speculative risk of gambling, where casino operators can apply the law of large numbers in a most efficient manner.

Finally, society may benefit from a speculative risk even though a loss occurs, but is harmed if a pure risk is present and a loss occurs. For example, a firm may develop new technology for producing inexpensive computers. As a result, some competi- tors may be forced into bankruptcy. Despite the bankruptcy, society benefits because the computers are produced at a lower cost. However, society nor- mally does not benefit when a loss from a pure risk occurs, such as a flood or earthquake that destroys a town or area.

Diversifiable Risk and Nondiversifiable Risk

Diversifiable risk is a risk that affects only individuals or small groups and not the entire economy. It is a risk that can be reduced or eliminated by diversification. For example, a diversified portfolio of stocks, bonds, and certificates of deposit (CDs) is less risky than a portfolio that is 100 percent invested in common stocks. Losses on one type of investment, say stocks, may be offset by gains from bonds and CDs. Likewise, there is less risk to a property and liability insurer if different lines of insurance are underwritten rather than only one line. Losses on one line can be offset by profits on other lines. Because diversifiable risk affects only specific individuals or small groups, it is also called nonsystematic risk or particular risk. Examples include car thefts, robberies, and dwelling fires. Only individuals and business firms that experience such losses are affected, not the entire economy.

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which was caused largely by systemic risk. The econ- omy experienced a massive financial meltdown and a brutal stock market crash that wiped out the life sav- ings of many Americans; the national unemployment rate soared to historically high levels; the housing market collapsed and foreclosures increased; more than 100 commercial banks and financial institutions failed or merged with other entities, which produced a credit crunch and a freezing of credit markets; com- mercial banks and some insurers sold billions of com- plex derivatives that were largely unregulated and resulted in massive losses to investors worldwide; and state and federal regulation of the financial services industry, including insurance companies, proved inad- equate and broken. Chapter 8 discusses in greater detail the economic impact of systemic risk on the insurance industry and government regulation of insurance.

Major personal risks anD CoMMerCial risks The preceding discussion shows several ways of clas- sifying risk. However, in this text, we emphasize pri- marily the identification and treatment of pure risk. Certain pure risks are associated with great economic insecurity for both individuals and families, as well as for commercial business firms. This section discusses (1) important personal risks that affect individuals and families and (2) major commercial risks that affect business firms.

Personal Risks

Personal risks are risks that directly affect an indi- vidual or family. They involve the possibility of the loss or reduction of earned income, extra expenses, and the depletion of financial assets. Major personal risks that can cause great economic insecurity include the following:3

■■ Premature death ■■ Inadequate retirement income ■■ Poor health ■■ Unemployment

Premature Death Premature death is defined as the death of a family head with unfulfilled financial

supermarket chain in 6 months may lose money if grain prices rise. A bank with a large portfolio of Treasury bonds may incur losses if interest rates rise. Likewise, an American corporation doing business in Japan may lose money when Japanese yen are exchanged for American dollars.

Enterprise risk is becoming more important in commercial risk management, which is a process that organizations use to identify and treat major and minor risks. In the evolution of commercial risk man- agement, some risk managers are now considering all types of risk in one program. Enterprise risk manage- ment combines into a single unified treatment pro- gram all major risks faced by the firm. As explained earlier, these risks include pure risk, speculative risk, strategic risk, operational risk, and financial risk. By packaging major risks into a single program, the firm can offset one risk against another. As a result, overall risk can be reduced. As long as all risks are not per- fectly correlated, the combination of risks can reduce the firm’s overall risk. In particular, if some risks are negatively correlated, overall risk can be significantly reduced. Chapter 4 discusses enterprise risk manage- ment in greater detail.

Treatment of financial risks typically requires the use of complex hedging techniques, financial deriva- tives, futures contracts, options, and other financial instruments. Some firms appoint a chief risk officer (CRO), such as the treasurer, to manage the firm’s financial risks. Chapter 4 discusses financial risk man- agement in greater detail.

Systemic Risk

Systemic risk is an economic risk that is extremely important in the monetary policy of the Federal Reserve, fiscal policies of the federal government, and government regulation of the economy. Systemic risk is especially important with respect to large commer- cial banks and other financial institutions that are considered too large to fail without doing major financial harm to a large part of the American economy.

Systemic risk is the risk of collapse of an entire system or entire market due to the failure of a single entity or group of entities that can result in the break- down of the entire financial system. The severe 2008– 2009 business recession in the United States was the second-worst economic downswing in U.S. history,

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was only 36,895, or 31 percent less.4 This amount generally is inadequate for retired workers with sub- stantial additional expenses, such as high uninsured medical bills, catastrophic long-term care costs in a skilled nursing facility, high property taxes, or a sub- stantial mortgage to be paid off.

In addition, most retired workers have not saved enough for a comfortable retirement. During the next 15 years, millions of American workers will retire. However, an alarming number will be financially unprepared for a comfortable retirement. According to a 2015 survey by the Employee Benefit Research Insti- tute, the amounts saved for retirement by the majority of retirees are relatively small. Retirees are individuals who are retired or who are age 65 or older and not employed full-time. The 2015 survey found that 53 percent of the retirees who responded to the survey reported total savings and investment of less than $25,000, which did not include their primary residence or any defined benefit pension plan. A disturbing per- centage of retirees (35 percent) reported relatively small and insignificant savings and investments of only $1,000 or less. Only 19 percent reported saving $250,000 or more for retirement (see Exhibit 1.1). In general, these amounts are relatively small and will not provide a comfortable retirement.

Finally, many retired people are living in poverty and are economically insecure. New poverty data show that aged poverty in old age is more severe than the official rate indicates. For 2014, the official poverty rate by the Census Bureau showed that only 10.0 percent of the people age 65 and over were counted as poor. How- ever, the official figure does not include the value of food stamps, payroll taxes, the earned income tax credit, work-related expenses, medical costs, child-care expenses, and geographical differences. The Census Bureau has developed a supplemental poverty measure that includes these factors and shows that the poverty rate for the aged is significantly higher than is com- monly believed. The new measure showed that the pov- erty rate for those individuals age 65 and older was estimated 15.5 percent, or about 55 percent higher than the official rate.5

Poor Health Poor health is another major personal risk that can cause great economic insecurity. The risk of poor health includes both the payment of cata- strophic medical bills and the loss of earned income.

obligations. These obligations include dependents to support, a mortgage to be paid off, children to edu- cate, and credit cards or installment loans to be repaid. If the surviving family members have insuffi- cient replacement income or past savings to replace the lost income, they will be exposed to considerable economic insecurity.

Premature death can cause economic insecurity only if the deceased has dependents to support or dies with unsatisfied financial obligations. Thus, the death of a 7-year-old child is not “premature” in the eco- nomic sense, as small children generally are not work- ing and contributing to the financial support of the family.

There are at least four costs that result from the premature death of a family head. First, the human life value of the family head is lost forever. The human life value is defined as the present value of the family’s share of the deceased breadwinner’s future earnings. This loss can be substantial; the actual or potential human life value of most college graduates can easily exceed $500,000. Second, additional expenses may be incurred because of funeral expenses, uninsured medi- cal bills, probate and estate settlement costs, and estate and inheritance taxes for larger estates. Third, because of insufficient income, some families may have trouble making ends meet or covering expenses. Finally, certain noneconomic costs are also incurred, including emotional grief, loss of a role model, and counseling and guidance for the children.

Inadequate Retirement Income The major risk dur- ing retirement is inadequate income. The majority of workers in the United States retire before age 65. When they retire, they lose their earned income. Unless they have sufficient financial assets on which to draw, or have access to other sources of retirement income—such as Social Security or a private pension, a 401(k) plan, or an individual retirement account (IRA)—they will be exposed to considerable economic insecurity.

The majority of workers experience a substantial reduction in their money incomes when they retire, which can result in a reduced standard of living. For example, according to the 2015 Current Population Survey, median money income for all households in the United States was $53,567 in 2014. In contrast, median income for householders aged 65 and older

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Social Security Administration, a 20-year-old worker has a 1-in-4 chance of becoming disabled before reaching the full retirement age.6 The financial impact of total disability on savings, assets, and the ability to earn an income can be severe. In particular, the loss of earned income during a lengthy disability can be financially devastating.

Students should know their chances of being una- ble to work because of sickness of injury and the esti- mated financial impact if they become disabled. Insight 1.1 provides a valuable disability income cal- culator by the Council of Disability Awareness (CDA) that shows the probability of becoming disabled and the financial impact of a long-term disability. The cal- culator provides a personal disability quotient, which shows the probability of becoming disabled and the estimated total financial loss if you cannot work for 3 months or longer. The results are based on your age, gender, occupation, anticipated retirement age, health status, and certain diseases. Check it out. You will be surprised at what you find.

Unemployment Unemployment is a major cause of economic insecurity in the United States. Unemploy- ment can result from business cycle downswings,

The costs of hospitalization, major surgery, diagnostic tests, and prescription drugs have increased substan- tially in recent years. Today, an open-heart operation can cost more than $300,000, a kidney or heart trans- plant can cost more than $500,000, and the costs of a crippling accident requiring several major opera- tions, plastic surgery, and rehabilitation can exceed $600,000. In addition, long-term care in a nursing home can cost $100,000 or more each year. Expensive prescription drugs taken daily present additional financial problems to many people. Chapter 15 dis- cusses in greater detail the economic problem of poor health and problems of the uninsured.

The loss of earned income is another major cause of economic insecurity if the disability is severe and lengthy. In cases of long-term disability, there is sub- stantial loss of earned income; medical bills are incurred; employee benefits may be lost or reduced; and savings are reduced or depleted. There is also the additional cost of providing care to a disabled person who is confined to the home. Most workers seldom think about the financial consequences of long-term disability. The probability of becoming disabled before age 65 is much higher than is commonly believed, especially by the young. According to the

Exhibit 1.1 Total Savings and Investments Reported by Retirees Among Those Providing a Response

2004 2010 2011 2012 2013 2014 2015

2015 Have Plan*

2015 No

Plan

Less than $1,000 28% 31% 29% 35%27% 28%

$1,000–$9,999 49% 19 16 17 11

812

6

8 12 7$10,000–$24,999 14

15 14

$25,000–$49,999 9 9

11 8

8 8

9$50,000–$99,999 7 6

13 11

7 10

$100,000–$249,999 17 15 12 12 10 11 10

$250,000 or More 15 *Have retirement plan defined as respondent or spouse having at least one of the following IRA, defined contibution plan or defined benifit plan.

12 17 15 17 17 19

12% 61%

10 13

9 5

11 5

14 5

15 5

30 6

Source: Employee Benefit Research Institute, “ The 2015 Retirement Confidence Survey: Having a Retirement Savings Plan a key factor in Americans’ Retirement Confidence,” Issue Brief No 413, April 2015, Table 19.

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unemployed workers are currently experiencing seri- ous problems of economic insecurity because of unemployment or underemployment.

Extended unemployment can cause economic insecurity in at least four ways. First, workers lose their earned income and employer-sponsored employee benefits. Unless there is sufficient replace- ment income or substantial past savings on which to draw, unemployed workers will be exposed to eco- nomic insecurity. Second, as stated earlier, hours of work may be cut, thereby reducing employees’ hours to only parttime. The reduced income may be insufficient in terms of the workers’ needs. Third, the problem of long-term unemployment has worsened in recent years. In December 2014, those jobless for 27 weeks or longer accounted for 31.9 percent of the unemployed in the United States.8 If the duration of unemployment extends over a long period, past savings and unemployment benefits may be exhausted.

Finally, because of complex laws and tighter eligibility requirements, state unemployment

technological and structural changes in the economy, seasonal factors, imperfections in the labor market, and other causes as well.

At the time of this writing, the economy in the United States continues to recover from the brutal 2008–2009 recession, which was one of the most severe recessions in the nation’s history, exceeded only by the Great Depression of the 1930s. In December 2014, the total unemployment rate was 5.6 percent,7 down from its peak of 10 percent in October 2009. However, totals conceal as much as they reveal. The true unemployment rate is understated because the official rate does not count certain groups as unem- ployed. These groups include workers who drop out the labor force because they are discouraged, workers forced into part-time employment because of eco- nomic conditions, and workers with a marginal attachment to the labor force. When a broader meas- urement of unemployment is used, the unemployment rate is 11.2 percent. Stated differently roughly one in nine workers in the United States is either unemployed or underemployed. As a result, millions of

What are Your Chances of not Being able to earn an income? Calculate Your personal Disability Quotient

I N S I g H T 1.1

The Council of Disability Awareness has developed a valuable disability income calculator, which enables you to calculate your personal disability quotient (PDQ), which is a way to calculate your odds of an injury or illness that could force you to miss work for weeks, months, or even years. The calculator, which gives you an estimate of the total financial impact of a severe illness or injury over your working career, is based on a variety of actuarial data and assumptions to determine the estimated odds of disability.

The calculation of your PDQ requires you to answer several questions—age and gender, height and weight, health status, tobacco use, whether you work indoors or outside, and whether you have been treated for certain diseases. In addition, you are asked your current income amount, expected rate of salary increases, and anticipated retirement age. It is a simple calculator to use, and you can calculate your PDQ in minutes.

Example: Brandon is age 25, 5 feet, 10 inches tall, weighs 170 pounds, and does indoor office work. He does not use tobacco, believes his health is average, and has not been treated for certain diseases, such as cancer or heart disease. He

earns $30,000 annually, expects salary increases of 3 percent annually, and plans to retire at age 67. If Brandon becomes totally disabled at age 25, what is his PDQ?

• Based on Brandon’s input, his PDQ is 13 percent, which reflects his own chance of becoming ill or injured and unable to work for 3 months or longer.

• If Brandon becomes disabled for 3 months, his chance of the disability lasting 5 years or longer is 32 percent.

• The average length of disability for someone like Brandon is 74 months.

• If Brandon can no longer earn an income, the loss of his earnings potential over the rest of his career is $2,460,696. This figure is a rough calculation based on his current income, expected rate of salary increases, and number of years until retirement.

Source: Calculated from the PDQ calculator, Council for Disability Awareness at http:// www.disabilitycanhappen.org/chances_disability/pdq.asp

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pay substantial damages to the person you have injured.

The United States is a litigious society, and law- suits are common. Motorists can be held legally liable for the negligent operation of their vehicles; home- owners may be legally liable for unsafe conditions on the premises where someone is injured; dog owners can be held liable if their dog bites someone; opera- tors of boats can be held legally liable because of bodily injury to boat occupants, swimmers, and water skiers. Likewise, if you are a physician, attor- ney, accountant, or other professional, you can be sued by patients and clients because of alleged acts of malpractice. Finally, business firms can be sued for defective products or services that result in bodily injury, property damage, and other harm to users of the product or service.

Liability risks are of great importance for several reasons. First, there is no maximum upper limit with respect to the amount of the loss. You can be sued for any amount. In contrast, if you own property, there is a maximum limit on the loss. For example, if your car has an actual cash value of $25,000, the maximum physical damage loss is $25,000. But if you are negligent and cause an accident that results in serious bodily injury to the other driver, you can be sued for any amount—$50,000, $500,000, $1 million, or more—by the person or party you have injured.

Second, a lien can be placed on your income and financial assets to satisfy a legal judgment. For exam- ple, assume that you injure someone, and a court of law orders you to pay damages to the injured party. If you cannot pay the judgment, a lien may be placed on your income and financial assets to satisfy the judg- ment. If you declare bankruptcy to avoid payment of the judgment, your credit rating will be impaired.

Finally, legal defense costs can be enormous. If you have no liability insurance, the cost of hiring an attorney to defend you can be staggering. If the suit goes to trial, attorney fees and other legal expenses can be substantial.

Commercial Risks

Business firms also face a wide variety of pure risks that can financially cripple or bankrupt the firm if a loss occurs. These risks include (1) property risks,

insurance programs have significant limitations and defects, which have increased the financial burden on unemployed workers. Not all unemployed workers receive unemployment insurance benefits; a relatively high percentage of claimants exhaust their unemploy- ment benefits during business recessions and are still unemployed; and many state programs are inade- quately financed. These issues are discussed in greater detail in Chapter 18.

Property Risks

Persons owning property are exposed to property risks—the risk of having property damaged or destroyed from numerous causes. Homes and other real estate and personal property can be damaged or destroyed because of fire, lightning, tornado, wind- storm, and numerous other causes. There are two major types of loss associated with the destruction or theft of property: direct loss and indirect or conse- quential loss.

Direct Loss A direct loss is defined as a financial loss that results from the physical damage, destruction, or theft of the property. For example, if you own a home that is damaged or destroyed by a fire, the physical damage to the home is a direct loss.

Indirect or Consequential Loss An indirect loss is a financial loss that results indirectly from the occur- rence of a direct physical damage or theft loss. For example, as a result of the fire to your home, you may incur additional living expenses to maintain your nor- mal standard of living. You may have to get a motel room or rent an apartment while the home is being repaired. You may have to eat some or all of your meals at local restaurants. You may also lose rental income if a room is rented and the house is not habit- able. These additional expenses that resulted from the fire would be a consequential loss.

Liability Risks

Liability risks are another important type of pure risk that most persons face. Under the U.S. legal sys- tem, you can be held legally liable if you do some- thing that results in bodily injury or property damage to someone else. A court of law may order you to

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continuing expenses that are not offset by revenues can be sizeable if the shutdown period is lengthy.

Finally, the firm may incur extra expenses during the period of restoration that would not have been incurred if the loss had not taken place. Examples include the cost of relocating temporarily to another location, increased rent at another location, and the rental of substitute equipment.

Cybersecurity and Identity Theft Cybersecurity and identity theft by thieves breaking into a firm’s com- puter system and database are major problems for many firms. Computer hackers have been able to steal hundreds of thousands of consumer credit records, which have exposed individuals to identity theft and violation of privacy. As a result, commercial banks, financial institutions, and other business firms are exposed to enormous legal liabilities. Other crime exposures include robbery and burglary; shoplifting; employee theft and dishonesty; fraud and embezzle- ment; piracy and theft of intellectual property, and computer crimes.

Other Risks Business firms must cope with a wide variety of additional risks, summarized as follows:

■■ Human resources exposures. These include job- related injuries and disease of workers; death or disability of key employees; group life and health and retirement plan exposures; and violation of federal and state laws and regulations.

■■ Foreign loss exposures. These include acts of ter- rorism, political risks, kidnapping of key person- nel, damage to foreign plants and property, and foreign currency risks.

■■ Intangible property exposures. These include damage to the market reputation and public image of the company, the loss of goodwill, and loss of intellectual property. For many compa- nies, the value of intangible property is greater than the value of tangible property.

■■ Government exposures. Federal and state govern- ments may pass laws and regulations that have a significant financial impact on the company. Examples include laws that increase safety stand- ards, laws that require reduction in plant emis- sions and contamination, and new laws to protect the environment that increase the cost of doing business.

(2) liability risks, (3) loss of business income, (4) cybersecurity and identity theft, and (5) other risks.

Property Risks Business firms own valuable business property that can be damaged or destroyed by numer- ous perils, including fires, windstorms, tornadoes, hurricanes, earthquakes, and other perils. Business property includes plants and other buildings; furni- ture, office equipment, and supplies; computers and computer software and data; inventories of raw mate- rials and finished products; company cars, boats, and planes; and machinery and mobile equipment. The firm also has accounts receivable records and may have other valuable business records that could be damaged or destroyed and expensive to replace.

Liability Risks Business firms often operate in highly competitive markets where lawsuits for bodily injury and property damage are common. The lawsuits range from small nuisance claims to multimillion-dollar demands. Firms are sued for numerous reasons, includ- ing defective products that harm or injure others, pol- lution of the environment, damage to the property of others, injuries to customers, discrimination against employees and sexual harassment, violation of copy- rights and intellectual property, and numerous other reasons. In addition, directors and officers may be sued by stockholders and other parties because of financial losses and mismanagement of the company. Finally, commercial banks, other financial institutions, and other business firms are exposed to enormous potential liability because of cyber security and iden- tify theft crimes that have occurred in recent years.

Loss of Business Income Another important risk is the potential loss of business income when a covered physical damage loss occurs. The firm may be shut down for several months because of a physical dam- age loss to business property due to a fire, tornado, hurricane, earthquake, or other perils. During the shutdown period, the firm would lose business income, which includes the loss of profits, the loss of rents if business property is rented to others, and the loss of local markets.

In addition, during the shutdown period, certain expenses may still continue, such as rent, utilities, leases, interest, taxes, some salaries, insurance premiums, and other overhead costs. Fixed costs and

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failed. To deal with this risk, Congress included a pro- vision in the Homeland Security Act of 2002, which limits the legal liability of companies that produce anti-terrorism technology. Without this provision, many anti-terrorism technologies would not be pro- duced because the liability risk is too great.

Worry and Fear

The final burden of risk is that of worry and fear. Numerous examples illustrate the mental unrest and fear caused by risk. Parents may be fearful if a teenage son or daughter departs on a ski trip during a blinding snowstorm because the risk of being killed on an icy road is present. Some passengers in a commercial jet may become extremely nervous and fearful if the jet encounters severe turbulence during the flight. A col- lege student who needs a grade of C in a course to graduate may enter the final examination room with a feeling of apprehension and fear.

teChniQues for Managing risk Techniques for managing risk can be classified broadly as either risk control or risk financing. Risk control refers to techniques that reduce the frequency or severity of losses. Risk financing refers to techniques that provide for the funding of losses. Risk managers typically use a combination of techniques for treating each loss exposure.

Risk Control

Risk control is a generic term to describe techniques for reducing the frequency or severity of losses. Major risk-control techniques include the following:

■■ Avoidance ■■ Loss prevention ■■ Loss reduction – Duplication – Separation – Diversification

Avoidance Avoidance is one technique for managing risk. For example, you can avoid the risk of being mugged in a high-crime area by staying away from

BurDen of risk on soCietY The presence of risk results in certain undesirable social and economic effects. Risk entails three major burdens on society:

■■ The size of an emergency fund must be increased. ■■ Society is deprived of certain goods and services. ■■ Worry and fear are present.

Larger Emergency Fund

It is prudent to set aside funds for an emergency. However, in the absence of insurance, individuals and business firms would have to increase substantially the size of their emergency fund to pay for unexpected losses. For example, assume you have purchased a $300,000 home and want to accumulate a fund for repairs if the home is damaged by fire, hail, wind- storm, or some other peril. Without insurance, you would have to save at least $50,000 annually to build up an adequate fund within a relatively short period of time. Even then, an early loss could occur, and your emergency fund may be insufficient to pay for the loss. If you are a middle- or low-income earner, you would find such saving difficult. In any event, the higher the amount that must be saved, the more cur- rent consumption spending must be reduced, which results in a lower standard of living.

Loss of Certain goods and Services

A second burden of risk is that society is deprived of important goods and services. For example, because of the risk of a liability lawsuit, many corporations have discontinued manufacturing certain products. Numerous examples can be given. Some 250 compa- nies in the world once manufactured childhood vac- cines; today, only a small number of firms manufacture vaccines, due in part to the threat of liability suits. Other firms have discontinued the manufacture of specific products, including asbestos products, foot- ball helmets, silicone-gel breast implants, and certain birth-control devices, because of fear of legal liability.

In addition, as a result of the September 11, 2001, terrorist attacks, Congress feared that companies manufacturing anti-terrorism technologies (such as airport security devices) would not manufacture their products for fear of being sued if the technology

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occurs. For example, back-up copies of key business records (e.g., accounts receivable) are available in case the original records are lost or destroyed.

Separation Another technique for reducing losses is separation. The assets exposed to loss are separated or divided to minimize the financial loss from a single event. For example, a manufacturer may store fin- ished goods in two warehouses in different cities. If one warehouse is damaged or destroyed by a fire, tor- nado, or other peril, the finished goods in the other warehouse are unharmed.

Diversification Finally, losses can be reduced by diversification. This technique reduces the chance of loss by spreading the loss exposure across different parties. Risk is reduced if a manufacturer has a num- ber of customers and suppliers. For example, if the entire customer base consists of only four domestic purchasers, sales will be impacted adversely by a domestic recession. However, if there are foreign cus- tomers and additional domestic customers as well, this risk is reduced. Similarly, the risk of relying on a single supplier can be minimized by having contracts with several suppliers.

From the viewpoint of society, loss control is highly desirable for two reasons. First, the indirect costs of losses may be large, and in some instances can easily exceed the direct costs. For example, a worker may be injured on the job. In addition to being respon- sible for the worker’s medical expenses and a certain percentage of earnings (direct costs), the firm may incur sizeable indirect costs: A machine may be dam- aged and must be repaired; the assembly line may have to be shut down; costs are incurred in training a new worker to replace the injured worker; and a con- tract may be canceled because goods are not shipped on time. By preventing the loss from occurring, both indirect costs and direct costs are reduced.

Second, the social costs of losses are reduced. For example, assume that the worker in the preceding example dies from the accident. Society is deprived forever of the goods and services the deceased worker could have produced. The worker’s family loses its share of the worker’s earnings and may experience considerable grief and economic insecurity. And the worker may personally experience great pain and suf- fering before dying. In short, these social costs can be reduced through an effective loss-control program.

high-crime rate areas; you can avoid the risk of divorce by not marrying; and business firms can avoid the risk of being sued for a defective product by not producing the product.

Not all risks should be avoided, however. For example, you can avoid the risk of death or disability in a plane crash by refusing to fly. But is this choice practical or desirable? The alternatives—driving or taking a bus or train—often are not appealing. Although the risk of a plane crash is present, the safety record of commercial airlines is excellent, and flying is a reasonable risk to assume.

Loss Prevention Loss prevention is a technique that reduces the probability of loss so that the frequency of losses is reduced. Several examples of personal loss prevention can be given. Auto accidents can be reduced if motorists take a safe-driving course and drive defensively. The number of heart attacks can be reduced if individuals control their weight, stop smok- ing, and eat healthy diets.

Loss prevention is also important for business firms. For example, strict security measures at airports and aboard commercial flights can reduce acts of ter- rorism; boiler explosions can be prevented by periodic inspections by safety engineers; occupational accidents can be reduced by the elimination of unsafe working conditions and by strong enforcement of safety rules; and fires can be prevented by forbidding workers to smoke in a building where highly flammable materials are used. In short, the goal of loss prevention is to reduce the probability that losses with occur.

Loss Reduction Strict loss prevention efforts can reduce the frequency of losses; however, some losses will inevitably occur. Thus, another objective of loss control is to reduce the severity of a loss after it occurs. For example, a department store can install a sprinkler system so that a fire will be promptly extin- guished, thereby reducing the severity of loss; a plant can be constructed with fire-resistant materials to minimize fire damage; fire doors and fire walls can be used to prevent a fire from spreading; and a commu- nity warning system can reduce the number of injuries and deaths from an approaching tornado.

Duplication Losses can also be reduced by duplication. This technique refers to having back-ups or copies of important documents or property available in case a loss

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premature death. Therefore, people who are not insured against this risk are using the technique of risk retention in a most dangerous and inap- propriate manner.

Self-Insurance Our discussion of retention would not be complete without a brief discussion of self- insurance. Self-insurance is a special form of planned retention by which part or all of a given loss exposure is retained by the firm. Another name for self-insur- ance is self-funding, which expresses more clearly the idea that losses are funded and paid for by the firm. For example, a large corporation may self-insure or fund part or all of the group health insurance benefits paid to employees.

Self-insurance is widely used in corporate risk management programs primarily to reduce both loss costs and expenses. There are other advantages as well. Self-insurance is discussed in greater detail in Chapter 3.

In summary, risk retention is an important tech- nique for managing risk, especially in modern corpo- rate risk management programs, which are discussed in Chapters 3 and 4. Risk retention, however, is appropriate primarily for high-frequency, low- severity risks where potential losses are relatively small. Except under unusual circumstances, risk retention should not be used to retain low-frequency, high- severity risks, such as the risk of catastrophic medical expenses, long-term disability, or legal liability.

Noninsurance Transfers Noninsurance transfers are another technique for managing risk. The risk is transferred to a party other than an insurance com- pany. A risk can be transferred by several methods, including:

■■ Transfer of risk by contracts ■■ Hedging price risks ■■ Incorporation of a business firm

Transfer of Risk by Contracts Undesirable risks can be transferred by contracts. For example, the risk of a defective television or stereo set can be transferred to the retailer by purchasing a service contract, which makes the retailer responsible for all repairs after the warranty expires. The risk of a rent increase can be transferred to the landlord by a long-term lease.

Risk Financing

As stated earlier, risk financing refers to techniques that provide for the payment of losses after they occur. Major risk-financing techniques include the following:

■■ Retention ■■ Noninsurance transfers ■■ Insurance

Retention Retention is an important technique for managing risk. Retention means that an individual or a business firm retains part of all of the losses that can result from a given risk. Risk retention can be active or passive.

■■ Active Retention Active risk retention means that an individual is consciously aware of the risk and deliberately plans to retain all or part of it. For example, a motorist may wish to retain the risk of a small collision loss by purchasing an auto insurance policy with a $500 or higher deduct- ible. A homeowner may retain a small part of the risk of damage to the home by purchasing a homeowners policy with a substantial deduct- ible. A business firm may deliberately retain the risk of petty thefts by employees, shoplifting, or the spoilage of perishable goods by purchasing a property insurance policy with a sizeable deduct- ible. In these cases, a conscious decision is made to retain part or all of a given risk. Active risk retention is used for two major reasons. First, it can save money. Insurance may not be pur- chased, or it may be purchased with a deduct- ible; either way, there is often substantial savings in the cost of insurance. Second, the risk may be deliberately retained because commercial insur- ance is either unavailable or unaffordable.

■■ Passive Retention Risk can also be retained pas- sively. Certain risks may be unknowingly retained because of ignorance, indifference, laziness, or failure to identify an important risk. Passive reten- tion is very dangerous if the risk retained has the potential for financial ruin. For example, many workers with earned incomes are not insured against the risk of total and permanent disabil- ity. However, the adverse financial consequences of total and permanent disability generally are more severe than the financial consequences of

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hedge may not be perfect. Transaction costs also are incurred. However, by hedging, the portfolio manager has reduced the potential loss in bond prices if interest rates rise.

Incorporation of a Business Firm Incorporation is another example of risk transfer. If a firm is a sole proprietorship, the owner’s personal assets can be attached by creditors for satisfaction of debts. If a firm incorporates, personal assets cannot be attached by creditors for payment of the firm’s debts. In essence, by incorporation, the liability of the stock- holders is limited, and the risk of the firm having insufficient assets to pay business debts is shifted to the creditors.

Insurance For most people, insurance is the most practical method for dealing with major risks. Although private insurance has several characteristics, three major characteristics should be emphasized. First, risk transfer is used because a pure risk is trans- ferred to the insurer. Second, the pooling technique is used to spread the losses of the few over the entire group so that average loss is substituted for actual loss. Finally, the risk may be reduced by application of the law of large numbers by which an insurer can predict future loss experience with greater accuracy. These characteristics are discussed in greater detail in Chapter 2.

The risk of a price increase in construction costs can be transferred to the builder by having a guaranteed price in the contract.

Finally, a risk can be transferred by a hold- harmless clause. For example, if a manufacturer of scaffolds inserts a hold-harmless clause in a contract with a retailer, the retailer agrees to hold the manu- facturer harmless in case a scaffold collapses and someone is injured.

Hedging Price Risks Hedging price risks is another example of risk transfer. Hedging is a technique for transferring the risk of unfavorable price fluctuations to a speculator by purchasing and selling futures con- tracts on an organized exchange, such as the Chicago Board of Trade or New York Stock Exchange.

For example, the portfolio manager of a pension fund may hold a substantial position in long-term U.S. Treasury bonds. If interest rates rise, the value of the Treasury bonds will decline. To hedge that risk, the portfolio manager can sell Treasury bond futures. Assume that interest rates rise as expected, and bond prices decline. The value of the futures contract will also decline, which will enable the portfolio manager to make an offsetting purchase at a lower price. The profit obtained from closing out the futures position will partly or completely offset the decline in the mar- ket value of the Treasury bonds owned. Of course, interest rates do not always move as expected, so the

Michael is a college senior who is majoring in marketing. He owns a high-mileage 2005 Ford that has a current mar- ket value of $2,500. The current replacement value of his clothes, television, stereo, cell phone, and other personal property in a rented apartment totals $10,000. He uses disposable contact lenses, which cost $200 for a six-month supply. He also has a waterbed in his rented apartment that has leaked in the past. An avid runner, Michael runs five miles daily in a nearby public park that has the reputa- tion of being extremely dangerous because of drug dealers, numerous assaults and muggings, and drive-by shootings. Michael’s parents both work to help him pay his tuition.

For each of the following risks or loss exposures, identify an appropriate risk management technique that could have been used to deal with the exposure. Explain your answer.

a. Physical damage to the 2005 Ford because of a col- lision with another motorist

b. Liability lawsuit against Michael arising out of the negligent operation of his car

c. Total loss of clothes, television, stereo, and personal property because of a grease fire in the kitchen of his rented apartment

d. Disappearance of one contact lens e. Waterbed leak that causes property damage to the

apartment f. Physical assault on Michael by gang members who

are dealing drugs in the park where he runs g. Loss of tuition assistance from Michael’s father,

who is killed by a drunk driver in an auto accident

CASE APPLICATION

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group of entities can result in the breakdown of the entire financial system.

■■ The following types of pure risk can threaten an indi- vidual’s economic security:

– Personal risks

– Property risks

– Liability risks

■■ Personal risks are those risks that directly affect an indi- vidual. Major personal risks include the following:

– Premature death

– Inadequate retirement income

– Poor health

– Unemployment

■■ A direct loss to property is a financial loss that results from the physical damage, destruction, or theft of the property.

■■ An indirect, or consequential, loss is a financial loss that results indirectly from the occurrence of direct physical damage or theft loss. Examples of indirect losses are the loss of use of the property, loss of profits, loss of rents, and extra expenses.

■■ Liability risks are extremely important because there is no maximum upper limit on the amount of the loss; a lien can be placed on income and assets to satisfy a legal judgment; and substantial court costs and attorney fees may also be incurred.

■■ Business firms face a wide variety of major risks that can financially cripple or bankrupt the firm if a loss occurs. These risks include property risks, liability risks, loss of business income, crime risks, and certain other risks.

■■ Risk entails three major burdens on society:

– The size of an emergency fund must be increased.

– Society is deprived of needed goods and services.

– Worry and fear are present.

■■ Risk control refers to techniques that reduce the fre- quency or severity of losses. Major risk-control tech- niques include avoidance, loss prevention, loss reduction, duplication, separation, and diversification.

■■ Risk financing refers to techniques that provide for the funding of losses after they occur. Major risk-financing techniques include retention, noninsurance transfers, and insurance.

suMMarY ■■ There is no single definition of risk. Risk historically has

been defined as uncertainty concerning the occurrence of a loss.

■■ A loss exposure is any situation or circumstance in which a loss is possible, regardless of whether a loss occurs.

■■ Objective risk is the relative variation of actual loss from expected loss. Subjective risk is uncertainty based on an individual’s mental condition or state of mind.

■■ Chance of loss is defined as the probability that an event will occur; it is not the same thing as risk.

■■ Peril is defined as the cause of loss. Hazard is any condi- tion that creates or increases the chance of loss.

■■ There are four major types of hazards. Physical hazard is a physical condition that increases the frequency or severity of loss. Moral hazard is dishonesty or character defects in an individual that increase the chance of loss. Attitudinal hazard (morale hazard) is carelessness or indifference to a loss that increases the frequency or severity of loss. Legal hazard refers to characteristics of the legal system or regulatory environment that increase the frequency or severity of losses.

■■ A pure risk is a risk where there are only the possibilities of loss or no loss. A speculative risk is a risk where either profit or loss is possible.

■■ Diversifiable risk is a risk that affects only individuals or small groups and not the entire economy. It is a risk that can be reduced or eliminated by diversification. In con- trast, nondiversifiable risk is a risk that affects the entire economy or large numbers of persons or groups within the economy, such as inflation, war, or a business reces- sion. It is a risk that cannot be eliminated or reduced by diversification.

■■ Enterprise risk is a term that encompasses all major risks faced by a business firm. Enterprise risk management combines into a single unified treatment program all major risks faced by the firm. Such risks include pure risk, speculative risk, strategic risk, operational risk, and financial risk.

■■ Financial risk refers to the uncertainty of loss because of adverse changes in commodity prices, interest rates, for- eign exchange rates, and the value of money.

■■ Systemic risk is the risk of collapse of an entire system or entire market in which the failure of a single entity or

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b. How does enterprise risk management differ from traditional risk management?

7. List the major types of pure risk that are associated with economic insecurity.

8. Describe the major social and economic burdens of risk on society.

9. Explain the difference between a direct loss and an indirect or consequential loss.

10. Identify the major risks faced by business firms.

11. a. Briefly explain each of the following risk-control techniques for managing risk: 1. Avoidance 2. Loss prevention 3. Loss reduction 4. Duplication 5. Separation 6. Diversification

b. Briefly explain each of the following risk-financing techniques for managing risk: 1. Retention 2. Noninsurance transfers 3. Insurance

appliCation Questions

1. Assume that the chance of loss is 3 percent for two dif- ferent fleets of trucks. Explain how it is possible that objective risk for both fleets can be different even though the chance of loss is identical.

2. Several types of risk are present in the U.S. economy. For each of the following, identify the type of risk that is present. Explain your answer.

a. The Department of Homeland Security alerts the nation of a possible attack by terrorists.

b. A house may be severely damaged in a fire. c. A family head may be totally disabled in a plant

explosion. d. An investor purchases 100 shares of Microsoft

stock. e. A river that periodically overflows may cause sub-

stantial property damage to thousands of homes in the floodplain.

f. Home buyers may be faced with higher mortgage payments if the Federal Reserve raises interest rates at its next meeting.

g. A worker on vacation plays the slot machines in a casino.

keY ConCepts anD terMs Attitudinal hazard (5) Avoidance (13) Chance of loss (4) Consequential loss (11) Direct loss (11) Diversification (risk

management) (14) Duplication (risk

management) (14) Diversifiable risk (6) Enterprise risk (6) Enterprise risk

management (7) Financial risk (6) Hazard (5) Hedging (16) Hold-harmless clause (16) Human life value (8) Incorporation (16) Indirect loss (11) Law of large numbers (3) Legal hazard (5) Liability risks (11) Loss exposure (3)

Loss prevention (14) Moral hazard (5) Nondiversifiable risk (6) Noninsurance transfers (15) Objective probability (4) Objective risk (3) Peril (4) Personal risks (7) Physical hazard (5) Premature death (7) Property risks (11) Pure risk (5) Retention (15) Risk (2) Risk control (13) Risk financing (13) Self-insurance (15) Separation (risk

management) (14) Speculative risk (5) Subjective probability (4) Subjective risk (3) Systemic risk (7)

revieW Questions

1. a. Explain the historical definition of risk. b. What is a loss exposure? c. How does objective risk differ from subjective risk?

2. a. Define chance of loss. b. What is the difference between objective probability

and subjective probability?

3. a. What is the difference between peril and hazard? b. Define physical hazard, moral hazard, attitudinal

hazard, and legal hazard.

4. a. Explain the difference between pure risk and specula- tive risk.

b. How does diversifiable risk differ from nondiversifi- able risk?

5. a. Explain the meaning of enterprise risk. b. What is financial risk? c. What is systemic risk?

6. a. What is enterprise risk management?

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financial impact if you cannot work for three months or longer. The results are based on your age, gender, occu- pation, anticipated retirement age, state of your health, and certain diseases. Visit the calculator site at disabilitycanhappen.org/chances_disability/pdq.asp

■■ The Employee Benefit Research Institute (EBRI) focuses solely on analyzing employee benefits. There is no lob- bying or advocacy. EBRI stands alone in employee ben- efits research as an independent, nonprofit, and nonpartisan organization. EBRI reports research data without spin or an underlying agenda. As such, research results are objective, independent, and nonpartisan and are widely used by private analysts, government policy- makers, and the media. Visit this important site at ebri.org

■■ The Huebner Foundation and Geneva Association act as an international clearinghouse for researchers and educa- tors in insurance economics and risk management. The Huebner foundation at Georgia State University provides graduate fellowships to promising scholars in the areas of risk management and insurance education. The Geneva Association is an international organization that promotes research dealing with worldwide insurance activities. Visit the site at huebnergeneva.org

■■ The Insurance Information Institute is a trade association that provides consumers with information relating to property and casualty insurance coverages and current issues. Visit the site at iii.org

■■ Risk Theory Society is an organization within the Ameri- can Risk and Insurance Association that promotes research in risk theory and risk management. Papers are distributed in advance to the members and are discussed critically at its annual meeting. Visit the site at aria.org/rts

■■ The Society for Risk Analysis (SRA) provides an open forum for all persons interested in risk analysis, includ- ing risk assessment, risk management, and policies related to risk. SRA considers threats from physical, chemical, and biological agents and from a variety of human activities and natural events. It is multidiscipli- nary and international. Visit the site at sra.org

■■ S.S. Huebner Foundation for Insurance Education sup- ports the advancement of university-level risk manage- ment and insurance courses, research, scholarship, and learning. Named for Professor Solomon S. Huebner, the

3. There are several techniques available for managing risk. For each of the following risks, identify an appropriate technique, or combination of techniques, that would be appropriate for dealing with the risk.

a. A family head may die prematurely because of a heart attack.

b. An individual’s home may be totally destroyed in a hurricane.

c. A new car may be severely damaged in an auto accident.

d. A negligent motorist may be ordered to pay a sub- stantial liability judgment to someone who is injured in an auto accident.

e. A surgeon may be sued for medical malpractice.

4. Andrew owns a gun shop in a high-crime area. The store does not have a camera surveillance system. The high cost of burglary and theft insurance has substantially reduced his profits. A risk management consultant points out that several methods other than insurance can be used to han- dle the burglary and theft exposure. Identify and explain two noninsurance methods that could be used to deal with the burglary and theft exposure.

5. Risk managers use a number of methods for managing risk. For each of the following, what method for han- dling risk is used? Explain your answer.

a. The decision not to carry earthquake insurance on a firm’s manufacturing plant

b. The installation of an automatic sprinkler system in a hotel

c. The decision not to produce a product that might result in a product liability lawsuit

d. Requiring retailers who sell the firm’s product to sign an agreement releasing the firm from liability if the product injures someone

internet resourCes ■■ The American Risk and Insurance Association (ARIA) is

the premier professional association of risk management and insurance educators and professionals. ARIA is the publisher of The Journal of Risk and Insurance and Risk Management and Insurance Review. Links are provided to research, teaching, and other risk and insurance sites. Visit the site at aria.org

■■ The Council of Disability Awareness (CDA) has a personal disability quotient (PDQ) calculator that shows the probability of becoming disabled and the estimated

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http;//aria.org
http://disabilitycanhappen.org/chances_disability/pdq.asp
http;//ebri.org
http://huebnergeneva.org
http;//iii.org
http://aria.org/rts
http://sra.org
2 0 C H A P T E R 1 / R I S k A N D I T S T R E A T m E N T

2. Risk has also been defined as (1) variability in future outcomes, (2) chance of loss, (3) possibility of an adverse deviation from a desired outcome that is expected or hoped for, (4) variation in possible out- comes that exist in a given situation, and (5) possibil- ity that a sentient entity can incur a loss.

3. George E. Rejda, Social Insurance and Economic Security, 7th ed. (Armonk, NY: M.E. Sharpe, 2012), 5–14.

4. U.S. Census Bureau, Income and Poverty in the United States: 2014 (Washington, DC: U.S.Government Printing Office, September 2015), Table 1.

5. U.S. Census Bureau, The Supplemental Poverty Meas- ure: 2014, Current Population Reports, P60-254, September 2015, Table 4b.

6. Disability Benefits, SSA Publication No. 05-10029, 2014.

7. Bureau of Labor Statistics, “The Employment Situa- tion—December 2014,” January 9, 2015. Accessed at http://www.bls.gov/news.release/pdf/empsit.pdf, January 21, 2015.

8. Ibid.

father of collegiate risk and insurance education, the Huebner Foundation is now located at Georgia State University in the J. Mack Robinson School of Business. The Huebner Foundation provides generous graduate fellowships to Ph.D. candidates who are capable of lead- ing and developing risk and insurance programs at uni- versities throughout the world. Visit the site at http://: huebnerfoundation.org

seleCteD referenCes Bernstein, Peter L. Against the Gods: The Remarkable

Story of Risk. New York: Wiley, 1996. Employee Benefit Research Institute. Employee Benefit

Research Institute, “The 2015 Retirement Confidence Survey: Having a Retirement Savings Plan a Key Fac- tor in Americans’ Retirement Confidence,” Issue Brief No. 413, April 2015.

The Insurance Fact Book 2015. New York: Insurance Information Institute.

Rejda, George E. “Causes of Economic Insecurity,” Social Insurance and Economic Security, 7th ed. Armonk, NY: M.E. Sharpe, 2012, pp. 5–14.

Wiening, Eric A. Foundations of Risk Management and Insurance. Boston: Pearson Custom Publishing, 2005.

notes 1. American Academy of Actuaries, Risk Classification

Work Group. On Risk Classification, A Public Policy Monograph (Washington, DC: American Academy of Actuaries, 2011), note 2, p.1.

Students may take a self-administered test on this chapter at

www.pearsonhighered.com/rejda

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http://www.bls.gov/news.release/pdf/empsit.pdf
http://www.pearsonhighered.com/rejda
2 1

“Insurance: An ingenious modern game of chance in which the player is permitted to enjoy the comfortable conviction that he is beating the man who keeps the table.”

Ambrose Bierce

Insurance and rIsk

After studying this chapter, you should be able to

■■ Explain the basic characteristics of insurance.

■■ Explain the law of large numbers.

■■ Describe the characteristics of an ideally insurable risk from the viewpoint of a private insurer.

■■ Identify the major insurable and uninsurable risks in our society.

■■ Describe the major types of insurance.

■■ Explain the social benefits and social costs of insurance.

Learning Object ives

2 CHAPTER

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insurance scholars, it is useful for analyzing the com- mon elements of a true insurance plan.

BAsiC CHARACTERisTiCs of insuRAnCE Based on the preceding definition, an insurance plan or arrangement typically includes the following characteristics:

■■ Pooling of losses ■■ Payment of fortuitous losses ■■ Risk transfer ■■ Indemnification

Pooling of Losses

Pooling or the sharing of losses is the essence of insur- ance. Pooling is the spreading of losses incurred by the few over the entire group, so that in the process,

DEfiniTion of insuRAnCE There is no single definition of insurance. Insurance can be defined from the viewpoint of several disci- plines, including law, economics, history, actuarial science, risk theory, and sociology. But each possible definition will not be examined at this point. Instead, we will examine the common elements that are typi- cally present in any insurance plan. However, before proceeding, a working definition of insurance—one that captures the essential characteristics of a true insurance plan—must be established.

After careful study, the Commission on Insurance Terminology of the American Risk and Insurance Association has defined insurance as follows.1 Insurance is the pooling of fortuitous losses by trans- fer 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 con- nected with the risk. Although this lengthy definition may not be acceptable to all risk managers and

Michael, age 25, graduated from a large eastern university with an accounting degree and accepted a job with a national accounting firm in Dallas, Texas. His immediate financial goal was to pay off a sizeable student loan of $40,000. Shortly after moving into a furnished apartment, Michael carelessly started a kitchen fire when he was cooking dinner. Personal property valued at $30,000 was totally destroyed. His apartment and an adjacent apartment were severely damaged. The management company sued Michael for the fire damage to the apartments and was awarded $125,000. Michael did not own a renters homeowners policy, which would have paid a substantial amount of the total loss. Michael’s goal of early repayment of the student loans received a serious financial setback.

Michael learned in a painful way the financial problem of being uninsured for the risk of fire and personal liability. In Chapter 1, we identified major personal and com- mercial risks that can cause great economic insecurity. For most people, private insur- ance is the most important technique for managing risk. Consequently, you should understand how insurance works. This chapter discusses the basic characteristics of insurance, characteristics of an ideally insurable risk, major types of private and gov- ernment insurance, and the social benefits and costs of insurance. The appendix at the end of the chapter discusses basic insurance statistics and the law of large numbers.

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pays $25,000. If both buildings are destroyed, each owner must pay $50,000. The expected loss for each owner remains $5,000 as shown below:

Expected loss = .81 * $0 + .09 * $25,000 + .90 * $25,000 + .01 * $50,000

= $5,000

Note that while the expected loss remains the same, the probability of the extreme values, $0 and $50,000, have declined. The reduced probability of the extreme values is reflected in a lower standard deviation as shown below:

SD = H.81(0-$5,000)2 + .09($25,000 -$5,000)2+ .09($25,000 - $5,000)2+ .01($50,000 - $5,000)2 SD = $10,607

Thus, as additional individuals are added to the pool- ing arrangement, the standard deviation continues to decline while the expected value of the loss remains unchanged. For example, with a pool of 100 insureds, the standard deviation is $1,500; with a pool of 1,000 insureds, the standard deviation is $474; and with a pool of 10,000, the standard deviation is $150.

In addition, by pooling or combining the loss experience of a large number of exposure units, an insurer may be able to predict future losses with greater accuracy. From the viewpoint of the insurer, if future losses can be predicted, objective risk is reduced. Thus, another characteristic often found in many lines of insurance is risk reduction based on the law of large numbers.

The law of large numbers states that the greater the number of exposures, the more closely will the actual results approach the probable results that are expected from an infinite number of exposures.2 For example, if you flip a balanced coin into the air, the a priori probability of getting “heads” is 0.5. If you flip the coin only 10 times, you may get heads eight times. Although the observed probability of getting heads is 0.8, the true probability is still 0.5. If the coin were flipped 1 million times, however, the actual number of heads would be approximately 500,000. Thus, as the number of random tosses increases, the actual results approach the expected results.

A practical illustration of the law of large num- bers is the National Safety Council’s prediction of the

average loss is substituted for actual loss. In addition, pooling involves the grouping of a large number of exposure units so that the law of large numbers can operate to provide a substantially accurate prediction of future losses. Ideally, there should be a large num- ber of similar, but not necessarily identical, exposure units that are subject to the same perils. Thus, pooling implies (1) the sharing of losses by the entire group and (2) the prediction of future losses with some accu- racy based on the law of large numbers.

The primary purpose of pooling, or the sharing of losses, is to reduce the variation in possible outcomes as measured by the standard deviation or some other measure of dispersion, which reduces risk. For exam- ple, assume that two business owners each own an identical storage building valued at $50,000. Assume there is a 10 percent chance in any year that each building will be destroyed by a peril, and that a loss to either building is an independent event. The expected annual loss for each owner is $5,000 as shown below:

Expected loss = .90 * $0 + .10 * $50,000 = $5,000

A common measure of risk is the standard deviation, which is the square root of the variance. The standard deviation (SD) for the expected value of the loss is $15,000, as shown below:

SD = 2.90(0 - $5,000)2 + .10($50,000 - $5,000)2 = $15,000

Suppose instead of bearing the risk of loss individu- ally, the two owners decide to pool (combine) their loss exposures, and each agrees to pay an equal share of any loss that might occur. Under this scenario, there are four possible outcomes:

Possible Outcomes Probability

Neither building is destroyed .90 * .90 = .81 First building destroyed, second building no loss

.10 * .90 = .09

First building no loss, second building destroyed

.90 * .10 = .09

Both buildings are destroyed .10 * .10 = .01

If neither building is destroyed, the loss for each owner is $0. If one building is destroyed, each owner

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insurer, who typically is in a stronger financial position to pay the loss than the insured. From the viewpoint of the individual, pure risks that are typically trans- ferred to insurers include the risk of premature death, excessive longevity, poor health, disability, destruction and theft of property, and personal liability lawsuits.

Indemnification

A final characteristic of insurance is indemnification for losses. Indemnification means that the insured is restored to his or her approximate financial position prior to the occurrence of the loss. Thus, if your home burns in a fire, a homeowners policy will indemnify you or restore you to your previous position. If you are sued because of the negligent operation of an automobile, your auto liability insurance policy will pay those sums that you are legally obligated to pay. Similarly, if you become seriously disabled, a disability-income insur- ance policy will restore at least part of the lost wages.

CHARACTERisTiCs of An iDEAlly insuRABlE Risk Private insurers generally insure only pure risks. How- ever, some pure risks are not privately insurable. From the viewpoint of a private insurer, an insurable risk ideally should have certain characteristics. There are ideally six characteristics of an insurable risk:

■■ There must be a large number of exposure units. ■■ The loss must be accidental and unintentional. ■■ The loss must be determinable and measurable. ■■ The loss should not be catastrophic. ■■ The chance of loss must be calculable. ■■ The premium must be economically feasible.

Large Number of Exposure Units

The first requirement of an insurable risk is a large number of exposure units. Ideally, there should be a large group of roughly similar, but not necessarily identical, exposure units that are subject to the same peril or group of perils. For example, a large number of wood frame dwellings in a city can be grouped together for purposes of providing property insurance on the dwellings.

The purpose of this first requirement is to enable the insurer to predict losses based on the law of large

number of motor vehicle deaths during a typical holi- day weekend. Because millions of vehicles are on the road, the National Safety Council has been able to predict with some accuracy the number of motorists who will die during a typical Fourth of July weekend. For example, assume that 500 to 700 motorists are expected to die during a typical July 4th weekend. Although individual motorists cannot be identified, the actual number of deaths for the group of motorists as a whole can be predicted with some accuracy.

However, for most insurance lines, actuaries gener- ally do not know the true probability and severity of loss. Therefore, estimates of both the average frequency and the average severity of loss must be based on previ- ous loss experience. If there is a large number of expo- sure units, the actual loss experience of the past may be a good approximation of future losses. As we noted earlier, as the number of exposure units increases, the relative variation of actual loss from expected loss will decline. Thus, actuaries can predict future losses with a greater degree of accuracy. This concept is important because an insurer must charge a premium that will be adequate for paying all losses and expenses during the policy period. The lower the degree of objective risk, the more confidence an insurer has that the actual pre- mium charged will be sufficient to pay all claims and expenses and provide a margin for profit.

A more rigorous statement of pooling and the law of large numbers can be found in the appendix at the end of this chapter.

Payment of Fortuitous Losses

A second characteristic of private insurance is the pay- ment of fortuitous losses. Most insurance policies exclude intentional losses. A fortuitous loss is one that is unforeseen and unexpected by the insured and occurs as a result of chance. In other words, the loss must be accidental. The law of large numbers is based on the assumption that losses are accidental and occur ran- domly. For example, a person may slip on an icy side- walk and break a leg. The loss would be fortuitous.

Risk Transfer

Risk transfer is another essential element of insurance. With the exception of self-insurance, a true insurance plan always involves risk transfer. Risk transfer means that a pure risk is transferred from the insured to the

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disabled. One accountant, however, may be more determined to return to work. If that accountant undergoes rehabilitation and returns to work, the disability-income benefits will terminate. Meanwhile, the other accountant would still continue to receive disability-income benefits according to the terms of the policy. In short, it is often difficult to determine when a person is actually disabled. However, all losses ideally should be both determinable and measurable.

The basic purpose of this requirement is to enable an insurer to determine if the loss is covered under the policy, and if it is covered, how much should be paid. For example, assume that Shannon has an expensive fur coat that is insured under a homeowners policy. It makes a great deal of difference to the insurer if a thief breaks into her home and steals the coat, or the coat is missing because her husband stored it in a dry- cleaning establishment but forgot to tell her. The loss is covered in the first example but not in the second.

No Catastrophic Loss

The fourth requirement is that ideally the loss should not be catastrophic. This means that a large propor- tion of exposure units should not incur losses at the same time. As we stated earlier, pooling is the essence of insurance. If most or all of the exposure units in a certain class simultaneously incur a loss, then the pooling technique breaks down and becomes unwork- able. Premiums must be increased to prohibitive lev- els, and the insurance technique is no longer a viable arrangement by which losses of the few are spread over the entire group.

Insurers ideally wish to avoid all catastrophic losses. In reality, however, that is impossible, because catastrophic losses periodically result from floods, hurricanes, tornadoes, earthquakes, forest fires, and other natural disasters. Catastrophic losses can also result from acts of terrorism.

Several approaches are available for meeting the problem of a catastrophic loss. First, reinsurance can be used by which insurance companies are indemnified by reinsurers for catastrophic losses. Reinsurance is an arrangement by which the primary insurer that initially writes the insurance transfers to another insurer (called the reinsurer) part or all of the potential losses associ- ated with such insurance. The reinsurer is then respon- sible for the payment of its share of the loss. Reinsurance is discussed in greater detail in Chapter 6.

numbers. Loss data can be compiled over time, and losses for the group as a whole can be predicted with some accuracy. The loss costs can then be spread over all insureds in the underwriting class.

Accidental and Unintentional Loss

A second requirement is that the loss should be acci- dental and unintentional; ideally, the loss should be unforeseen and unexpected by the insured and outside of the insured’s control. Thus, if an individual delib- erately causes a loss, he or she should not be indemni- fied for the loss.

There are several reasons for this requirement. First, the loss should be accidental because the law of large numbers is based on the random occurrence of events. A deliberately caused loss is not a random event because the insured knows when the loss will occur. Thus, prediction of future experience may be highly inaccurate if a large number of intentional or nonrandom losses occur. Second, moral hazard is increased if the insured deliberately intends to cause a loss. Finally, it is poor public policy to allow insureds to collect for intentional losses.

Determinable and Measurable Loss

A third requirement is that the loss should be both determinable and measurable. This means the loss should be definite as to cause, time, place, and amount. Life insurance, in most cases, meets this requirement easily. The cause and time of death can usually be readily determined, and if the person is insured, the face amount of the life insurance policy is the amount paid.

Some losses, however, are difficult to determine and measure. For example, under a disability-income policy, the insurer promises to pay a monthly benefit to the disabled person if the definition of disability stated in the policy is satisfied. Some dishonest claim- ants may deliberately fake sickness or injury to collect from the insurer. Even if the claim is legitimate, the insurer must still determine whether the insured satis- fies the definition of disability stated in the policy. Sickness and disability are highly subjective, and the same event can affect two persons quite differently. For example, two accountants who are insured under separate disability-income contracts may be injured in an auto accident, and both may be classified as totally

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Based on the preceding requirements, most per- sonal risks, property risks, and liability risks can be privately insured because the ideal characteristics of an insurable risk generally can be met. In contrast, most market risks, financial risks, production risks, and political risks are difficult to insure by private insurers.4 These risks are speculative, and calculation of a correct premium may be difficult because the chance of loss cannot be accurately estimated. For instance, insurance that protects a retailer against loss because of a change in consumer tastes, such as a style change, generally is not available. Accurate loss data are not available. Thus, it would be difficult to calcu- late an accurate premium. The premium charged may or may not be adequate to pay all losses and expenses. Since private insurers are in business to make a profit, certain risks are difficult to insure because of the pos- sibility of substantial losses.

Two APPliCATions: THE Risks of fiRE AnD unEmPloymEnT You will understand more clearly the requirements of an insurable risk if you can apply these requirements to a specific risk. For example, consider the risk of fire to a private dwelling. This risk can be privately insured because the requirements of an insurable risk are generally fulfilled (see Exhibit 2.1).

Consider next the risk of unemployment. How well does the risk of unemployment meet the ideal requirements of an insurable risk? As is evident in Exhibit 2.2, the risk of unemployment does not completely meet the requirements.

First, predicting unemployment is difficult because of the different types of unemployment and labor. There are professional, highly skilled, semi- skilled, unskilled, blue-collar, and white-collar work- ers. Moreover, unemployment rates vary significantly by occupation, age, gender, education, marital status, city, state, and a host of other factors, including gov- ernment programs and economic policies that fre- quently change. In addition, the outsourcing of jobs to foreign countries by major corporations is another major problem in the United States, which makes the risk of unemployment more difficult to measure and insure privately. Also, the duration of unemployment varies widely among the different groups. Because a large number of workers can become unemployed at

Second, insurers can avoid the concentration of risk by dispersing their coverage over a large geo- graphical area. The concentration of loss exposures in a geographical area exposed to frequent floods, earth- quakes, hurricanes, or other natural disasters can result in periodic catastrophic losses. If the loss expo- sures are geographically dispersed, the possibility of a catastrophic loss is reduced.

Finally, financial instruments are now available for dealing with catastrophic losses. These instru- ments include catastrophe bonds, which are designed to help fund catastrophic losses. Catastrophe bonds are discussed in Chapters 4 and 6.

Calculable Chance of Loss

Another requirement is that the chance of loss should be calculable. The insurer must be able to calculate both the average frequency and the average severity of future losses with some accuracy. This requirement is necessary so that a proper premium can be charged that is sufficient to pay all claims and expenses and yields a profit during the policy period.

Certain losses, however, are difficult to insure because the chance of loss cannot be accurately esti- mated, and the potential for a catastrophic loss is pre- sent. For example, floods, wars, and cyclical unemployment occur on an irregular basis, and pre- diction of the average frequency and severity of losses is difficult. Thus, without government assistance, these losses are difficult for private carriers to insure.

Economically Feasible Premium

A final requirement is that the premium should be eco- nomically feasible. The insured must be able to afford the premium. In addition, for the insurance to be an attractive purchase, the premiums paid must be substan- tially less than the face value, or amount, of the policy.

To have an economically feasible premium, the chance of loss must be relatively low. One view is that if the chance of loss exceeds 40 percent, the cost of the policy will exceed the amount that the insurer must pay under the contract.3 For example, an insurer could issue a $1,000 life insurance policy on a man who is age 99, but the pure premium would be close to that amount, and an additional amount for expenses would also have to be added. The total pre- mium would exceed the face amount of insurance.