Insurance Principles

Summary

The webinar, presented by Dr. RB Drenan Jr., concentrates on providing a comprehensive understanding of insurance fundamentals specifically tailored for policymakers. It covers the basics of insurance, delves into the unique aspects of insurance pricing, the regulatory framework, and highlights the critical role of insurance as a risk management tool. From defining key terms like risk, hazard, and moral hazard, to discussing how insurers transfer financial risks, the seminar is aimed at enhancing knowledge on how these elements affect both individuals and organizations. It further explains the principles underlying insurance practices such as indemnification, the law of large numbers, and insurable interest, ultimately showcasing the industry's significance in economic stability and consumer protection.

Highlights

• Dr. Drenan explains pure risk versus speculative risk; only pure risks are insurable. 🎲
• Moral hazard, such as fraudulent claims, can impact insurance costs significantly. 🔍
• The role of insurance in supporting credit and investment, showcasing its economic importance. 💸
• Understanding principles like indemnification and the law of large numbers is key to comprehending insurance. 📐
• Various risk management techniques, including retention and transfer, are crucial for businesses. 🔄

Key Takeaways

• Insurance is essential for providing economic security to individuals and businesses. 💼
• Understanding risk management, particularly pure and speculative risks, is crucial for effective insurance. 🎯
• Insurers operate by pooling risks and rely on statistical laws to predict losses effectively. 📊
• Regulations ensure consumer protection and maintain insurer solvency. 🛡️
• Moral and morale hazards can increase the cost of insurance, making understanding these concepts vital. 🚦

Overview

Dr. RB Drenan Jr. meticulously outlines the foundational concepts of insurance, elucidating terms such as pure risks and speculative risks, crucial for grasping how insurance functions. He emphasizes that only pure risks are normally insurable, setting the stage for deeper exploration into insurance mechanisms.

The seminar also tackles the intricate aspects of moral and morale hazards in the insurance sector, underlining how they affect pricing and risk management. Dr. Drenan discusses various strategies insurers use to mitigate these issues, highlighting the importance of principles like indemnification in creating robust insurance contracts.

Additionally, Dr. Drenan provides insights into the regulatory environment of the insurance industry. By explaining the necessity of regulations in ensuring consumer protection and maintaining insurer solvency, he underscores the importance of these measures in preserving market stability and trust in the insurance system.

Chapters

• 00:00 - 00:30: Introduction and Speaker's Credentials The chapter introduces Dr. RB Drenan Jr., who holds multiple prestigious positions at the Fox School of Business at Temple University. He is an associate professor and chairman specializing in risk management, insurance, and healthcare management. Additionally, he is recognized as a distinguished teaching fellow. Dr. Drenan has an impressive educational background with undergraduate degrees in economics, mathematics, and biology from Southern Methodist University.
• 00:30 - 01:00: Research and Webinar Overview This chapter introduces Dr. Drenan, who holds advanced degrees in insurance and risk management from the Wharton School. Dr. Drenan's research focuses on managed care and employee benefits, and he has contributed articles to numerous scholarly journals. The chapter highlights his expertise in the field as he joins a webinar to share insights.
• 01:30 - 02:00: Insurance Basics and Importance The chapter introduces the fundamental concepts of insurance and risk management. It is the first in a series of webinars aimed at policy makers, designed to cover essential aspects of insurance. Future installments will cover topics such as insurance coverages for property, casualty, life and health, as well as insurance regulation and legislation.
• 02:30 - 04:00: Risk, Perils, and Hazards The chapter begins with an introduction to the topics that will be covered, focusing on the basics of insurance, economic issues related to insurance pricing, and the unique characteristics of insurance products. It highlights insurance as a tool for risk management and discusses its role in organizational risk management. The chapter also touches on the regulation of insurance operations, promising a brief discussion on the reasons behind the need for regulation. The initial focus is on understanding the foundational aspects of insurance.
• 06:00 - 07:00: Insurance Indemnity and Law of Large Numbers The chapter titled 'Insurance Indemnity and Law of Large Numbers' introduces the topic by discussing how insurance serves as a fundamental tool for providing economic security to individuals, businesses, and organizations. The narrative starts with an engagement or icebreaker, hinting at the broader societal implications of insurance issues such as healthcare insurance, homeowners insurance, and workplace-related insurance. The initial discussion sets the stage for exploring how these types of insurances impact constituents and the significance of managing risks through the law of large numbers and indemnity in insurance.
• 14:00 - 20:00: Insurance Costs and Moral Hazards The chapter titled 'Insurance Costs and Moral Hazards' begins with an introduction to compensation and auto insurance, setting a foundation for the concepts discussed throughout the webinar series. It highlights the importance of defining key terminology, beginning with the concept of 'risk' in insurance and risk management. The chapter focuses on 'pure risk,' which is described as the uncertainty regarding future outcomes. The initial discussion sets the stage for understanding how risk influences insurance costs and the potential for moral hazards.
• 22:00 - 23:00: Insurance Principles and Regulation This chapter introduces the concept of risk, specifically focusing on uncertainties related to losses or events that might result in losses. It distinguishes between different types of risks, such as pure risk, which involves the potential for loss, and speculative risk, which could result in a gain. Examples of speculative risks include gambling and investing in stocks. The chapter sets the foundation for understanding insurance by exploring these basic risk concepts.
• 26:00 - 30:00: Insurable Interest and Insurance Pricing The chapter begins with a distinction between speculative risks and pure risks, emphasizing that the latter are generally insurable. The focus remains on pure risks in the context of insurance and risk management.
• 40:00 - 47:00: Managing Risk with Insurance The chapter titled 'Managing Risk with Insurance' introduces the concept of risk management by differentiating between perils and hazards. It explains that perils are pure risk events, representing the immediate causes of loss, such as fires. Hazards, on the other hand, are conditions or situations that increase the likelihood of a peril occurring. An example of a hazard provided is a drunk driver, who represents a more significant risk compared to a standard driver. The chapter likely explores how understanding these differences is crucial in the realm of insurance and risk management.
• 46:00 - 53:00: Insurance Regulation and Consumer Protection In this chapter, the concept of hazard is discussed in the context of insurance. The question posed is what constitutes a hazard, and the example given is the act of driving, which inherently carries the risk of accident involvement. The chapter emphasizes that while driving in itself does not directly cause an accident, engaging in risky behavior such as driving under the influence increases the probability of an accident occurring. Therefore, in terms of insurance, a hazard is not the direct cause of a loss but a factor that raises the likelihood of a peril, such as an accident, taking place. This highlights the importance of understanding hazards for both risk assessment and consumer protection within the realm of insurance regulation.

Insurance Principles Transcription

• 00:00 - 00:30 please allow me to introduce our speaker RB drenan Jr is associate risk Professor associate professor of risk management and insurance and chairman of the Department of Risk insurance and healthc Care Management at the fox School of Business at Temple University he has also been designated as Fox School Dean's distinguished teaching fellow Dr jenan received undergraduate degrees in economics mathematics and biology from Southern Methodist University
• 00:30 - 01:00 he earned his master's degree in PhD in insurance and risk management from the Wharton School of the University of Pennsylvania Dr drenan conducts research on managed care and employee benefits and has published articles in the Journal of insurance regulation the cpcu journal benefits quarterly and the Journal of insurance issues Rob we're pleased to have you here today thank you Marty and and W and welcome to all those who are
• 01:00 - 01:30 participating in our our first webinar U again this is Insurance uh fundamentals for policy makers this is sort of U insurance and risk management 101 um the remaining uh three webinars as you can see are Insurance coverages Property and Casualty I'll be returning in a few weeks to do insurance coverages life and health and then the final uh installment in the sequence will be Insurance regulation and legislation
• 01:30 - 02:00 um so the topics that I'm going to discuss today um are looking at Insurance Basics also looking at some economic issues related to Insurance pricing Insurance pricing is very unique uh looking at some of the characteristics of the insurance product insurance is a risk management tool how it fits broadly into managing risk for most firms and organizations and then finally we'll have a brief discussion as to why Insurance operations are regulated so we'll look at Insurance based Basics first uh insurance is uh a
• 02:00 - 02:30 fundamental tool to provide Economic Security uh to firms individuals and organizations uh so we first have to um consider an icebreaker thanks Rob uh here's some food for thought uh for you and for our audience today issues associated with these types of insurance concerns may have an impact on your constituents and we've listed healthc care Insurance homeowners insurance work at
• 02:30 - 03:00 compensation and auto insurance so to begin our our discussion uh we need to sort of get some terminology out of the way these are pretty fundamental concepts that we will be referring to throughout our webinar throughout the remaining webinars so first we have to Define what is risk uh in insurance and risk management we deal with a type of risk known as pure risk uh and pure risk really is uncertainty regarding future outcomes and in particular the typ when we say P risk
• 03:00 - 03:30 it's and certainty regarding a loss or events which might produce a loss so um you could think about in the future there might be two possible states of the world U some random event could occur and you could have a loss uh or random event did not occur and you don't have a loss there are certainly other types of risk uh which involve possibility of a gain that's called a speculative risk situation so gambling for example or buying stock uh those are examples of speculative risk
• 03:30 - 04:00 um speculative risk is not an insurable risk pure risks uh generally speaking are insurable and so the types of risk that we talk about in insurance and risk management are almost exclusively pure risk eventss we also have this uh term called apparel apparel is the defined as the immediate cause of a loss so a fire is apparel of theft uh floods earthquakes death uh negligent acts these are all examples of perils they're also r events um so when they occur when
• 04:00 - 04:30 a fire occurs there's a loss that's forthcoming if no fire occurs there's no loss so the types of perils that I've mentioned to you are pure risk events so a Peril is the immediate cause of the loss but also is something associated with insurance and risk management called a hazard um hazards and perils are really easy to get mixed up but they are very different U so I'll give you an example of a hazard uh a drunk driver uh is a hazard as as opposed to a driver
• 04:30 - 05:00 who's not drunk so in what sense is that a hazard well anytime anyone gets behind an automobile there's a possibility that they could get involved in an accident uh if they're driving drunk then the probability or the possibility of them getting involved in an accident is actually increased so it increases the likelihood of a particular accident occurring so it didn't caused the loss but it made the Peril the accident in this case more likely to happen a second advant second
• 05:00 - 05:30 example of a hazard would be um let's say that you consider the distance U of A structure from the nearest source of water so a fire hydrant or firehouse um if you're if you're right next door to a fire hydrant if a fire occurs then you have a reliable source of water meaning that the fire will not be as extensive perhaps if you're a long way from a source of water and if a fire occurs then uh the fire will go um longer and the Damage will be greater
• 05:30 - 06:00 so what we notice about hazards is that they don't cause losses to occur but when we do have hazards they increase either the frequency or be the probability or they increase the dollar amount of the loss so they don't cause losses to happen but they increase uh the probability of the loss or the dollar amount that it happens now hazards are important uh because they do affect insurance contracts as we're going to see and they're also an important part of how firms might might manage risk in their organizations um fundamentally we consider losses losses are are as a
• 06:00 - 06:30 result of perils uh some losses are easily measurable so most property losses uh there's a loss to property for example uh it's pretty easy to measure the repair cost or replacement cost uh if someone dies there's a loss of income that's easy to measure but if someone dies it may also be a loss of companionship or advice that's not so easy to measure uh typically we think of uh losses in insurance and risk management that can be measured uh because Insurance cont contracts deal
• 06:30 - 07:00 with losses that are easily measurable as we will see the next two concepts are related uh loss frequency and loss severity so to give you an example here suppose that you were buying a firm and you looked at this firm's financial statements you looked their balance sheet in their income statement and on their income statement you noticed an expense item called self-insured workers compensation losses um so of course states require virtually every state requires firms to provide Workers Compensation Insurance or workers comp compensation coverage for their
• 07:00 - 07:30 employees are injured on the job uh some firm some states allow firms to self-insure to not buy an insurance contract to Simply pay for those losses themselves so if you were buying a firm you're buying uh the assets and liabilities and all the risks associated with that firm so if you were to see that uh self-insured workers compensation losses was an expense item and it was a million dollars um then you might want to dig further and know well how did we get to that million dollar figure did we have one workplace
• 07:30 - 08:00 accident for example that caused someone to be severely injured and the amount of that loss is going to be a million dollars or did we have 10 workplace accidents and each accident costs $100,000 both examples would yield a million dollars but in terms of how you got there um it make a big difference from a risk management perspective so some events some types of losses or perils um and what will we call low frequency events or low probability events some are very very low
• 08:00 - 08:30 probability events um so a hurricane Sandy type situation floods are not unusual but a hurricane Sandy situation was a pretty low probability event but when it happened it caused a great deal of damage so that would be severity severity is really high so so we can say that uh frequency is basically looking at U How likely a loss is to happen what the probability of that loss is um and then some events are lower frequency losses some are higher frequency losses
• 08:30 - 09:00 U severity is given I've had a loss how much is it going to be so obviously if I have no loss on the profile of frequency and severity uh some risk management tools including Insurance are better Suited uh than others as we will see a little
• 09:00 - 09:30 bit later on so of course insurance is a very common way of of handling risk or uncertainty and so we can see here that the definition you see on your screen perhaps is a it's a means of treating Risk by transferring the financial consequences of loss to a third party and this third party uh is an insurance firm or an insurer and it's also a means of protecting Financial interests when losses uh do occur so we're going to talk a little bit later about really what is the commodity what is it that you're buying when you buy an insurance contract um so
• 09:30 - 10:00 basically what you do when you buy insurance you recognize that random events could happen to you that could cause you to have losses and what you're doing is you're transferring the financial responsibility of that loss to a third party called an insurer you're not really insuring the you're not really transferring the risk per se if you own a property if you own house or a building you are subject to various what we call property loss exposures um your property could could be damaged by fire right you have you own that so you'd be
• 10:00 - 10:30 financially responsible for it by buying an insurance contract you still own the property you still face the loss exposure but now you've got an ally to help you pay for the financial consequences of that so how do insurance and insurance contracts benefit insurance uh so insured is of course one one party to the contract we have the insur on the one hand and the insurer insured on the other uh insurance contracts indentify their customers so basically we could call uh insurance contracts contracts of
• 10:30 - 11:00 Indemnity there are other contracts of Indemnity that are in the marketplace but insurance is the is the most common example so what happens when an individual has a loss is that insurers indemnify their customers they provide a form of indemnification uh to indemnify someone means to uh compensate them and perhaps to make them financially whole uh but we'll talk more about that a little bit later but basically insurance contracts indemnify I have a loss I finally payment with my insurer and my insurer
• 11:00 - 11:30 compensates me they indemnify me they provide some sort of financial resolution to that loss uh it also reduces uncertainty in the sense that um I know that if I have an insurance contract in the event that I have a loss which again I don't know if I'm going to have a loss or not I don't know how much that loss is going to be but I know that in the event that I have a loss uh that the insurer will provide some sort of financial restitution for that so in a sense it reduces uh the uncertainty um one could say that when you buy and insurance and you pay a premium to an
• 11:30 - 12:00 insurer it's like paying a known loss without insurance you are faced with a situation where you may or may not have to pay out a loss with insurance uh you pay a known loss in the form of a premium that also encourages um efficient use of resources imagine if you will if firms did not have access to insurance and they had to save money they had to set money aside in very liquid form to be able to pay a loss when in fact it happened that would perhaps be a very inefficient use of
• 12:00 - 12:30 those resources and also insurance and insurance contracts and insurers provide incented to their customers uh to reduce and prevent losses there are numerous examples of this in auto insurance and various types of property insurance and work as Compensation Insurance and many insurers actually are partners with their customers in those efforts how does Insurance uh uh benefit U businesses and Society uh supports credit um you as a bank would not loan
• 12:30 - 13:00 money to someone an organization or a business or an individual if they did not have property proper insurance on the asset that they were loaning money for um also it satisfies various legal requirements individuals of course have to have auto insurance in Most states uh Workers Compensation Insurance is another and of course a new uh requirement that has emerged uh recently is with the Affordable Care Act uh individuals have to have health insurance firms will have to provide
• 13:00 - 13:30 health insurance to their employees beginning uh in 2015 uh it also satisfies business requirements so you may have a contractor that comes on to your work site or to your your your place of business or your home um you would want them to have adequate liability insurance to cover any any losses they may have caused uh Insurance firms are a big source of investable capital uh they collect premium dollars they pay losses out later and depending upon the type of insurance they maybe uh opportunities to
• 13:30 - 14:00 uh take those monies and invest it and so Insurance firms are a good source of investable capital for a lot of a lot of a lot of projects in the United States and also reduces social burden again imagine if you will a situation where people did not have access to insurance or Insurance markets and uh random things happened to them either personally or to their property and uh they would U uh be destitute for example they would be uh uh in need of various
• 14:00 - 14:30 types of disaster relief or charity and so it reduces those social burdens that might be forthcoming uh what is the cost of insurance to insures well clearly the most obvious cost the direct cost is uh premiums uh insures you to pay premium dollars uh that's money you give to an insurer and uh certainly um that has an opportunity cost meaning the more money you give to an insurer U that is money that you can't use for an alternative Pur purpose you can't invest that in
• 14:30 - 15:00 other assets and so there is an indirect cost to buying Insurance because you're tying up funds if you will with the insurance firm in the form of a premium when you you may have an alternative use for that which would be a positive gain what are the costs associated with insurance well clearly that's uh we have operating costs now an economists we call that transactions cost so an insurance firm does provide contracts of indignity that's what they sell uh but firms do have operating expenses right
• 15:00 - 15:30 they have employees they have property they have to maintain they have distribution expenses they have advertising expenses they premium taxes that states charge them and uh depending upon the type of insurance firm and how they're how they're constructed or how they're formed they may also include a profit uh if it's a stock insurance company they have investors investors should want a rate of return on their on Capital so that insurance firms might make a profit um another another um cost associated with uh insurance is
• 15:30 - 16:00 notice the next two have to do with hazards um so we have here moral hazard and then uh morale Hazard um so U I'm going to take morale Hazard first and then come back to the moral hazard issue so again if you recall from our previous discussion a hazard is something that increases either the frequency or the probability of a loss or the severity of the loss so it makes losses more likely to happen or it makes is more severe than in the absence of the hazard there
• 16:00 - 16:30 are some physical hazards of course but then there are also these things called morale and moral hazards so we'll look at the third bullet point or alhazard first um so these basically are uh types of claims or losses that are caused by carelessness or indifference uh on the part of the insured so individuals who perhaps text while they're driving uh or people who don't uh uh lock up their property or student students I have who in this who in the tech center on campus
• 16:30 - 17:00 and they have iPads and iPhones and laptops and they walk off and leave them because they're just very forgetful those are typs and then and then they're stolen afterwards that's a morale Hazard issue but then we also have this issue of moral hazard so I want to spend a little bit of time on this because moral hazard is an important part of any insurance transaction so moral hazard uh the classic examples would be as you can see here fraudulent activity INF claims
• 17:00 - 17:30 things we would probably call insurance fraud and those are definitely examples of moral hazard arson uh murdering someone for life insurance proceeds uh that those are examples of moral hazard um and the reason why they're called moral hazard I suspect is because this activity involves Behavior which is morally suspect however there are other examples of moral hazard and insurance contracts U so for example if someone becomes unemployed maybe they maybe they become unemployed through no fault of
• 17:30 - 18:00 their own and they have 18 months of unemployment insurance uh then they may be not very careful about looking for a job they may not be as diligent about looking for a job as they would be if they didn't have unemployment insurance so even though unemployment insurance may not have caused them to become unemployed the fact that they're not aggressively looking for a job that might that is actually increase the severity of the loss um and that would be considered a moral hazard as well so what I like to think of moral hazard is
• 18:00 - 18:30 is I think well moral hazard is when someone has insurance or things that look a whole lot like Insurance like disaster relief uh then their behavior changes and their behavior changes in a way to increase frequency or severity of losses I'll give you one more example of what I would consider to be moral hazard uh when I give an exam to my students and if the average is 65 they all want to know is there a curve or not if I gave them a 10 point curve I've just
• 18:30 - 19:00 given them something that's like Insurance I've given them great insurance and so if I give them a 10-point curve to bail them out because they didn't study as much they probably won't study as much next time so that be get get it to behavior change so moral hazard is something that is present in all types of insurance it's just a matter of how much moral hazard there is and what degree it is so what we worry about a lot in insur in controlling insurance contracts is controlling moral hazard so again moral hazard would be
• 19:00 - 19:30 the case where someone's insured and that changes their behavior in a way to increase frequency or severity of lawsuit sometimes that behavior change is immorally illegal or or against the law and sometimes it's not uh frivolous lawsuits that are settled as's claims that's also a cost associated with insurance um one would imagine there wouldn't be as many frivolous lawsuits if people didn't have insurance so that's also an example of moral hazard as well thanks Rob and we've arrived at the
• 19:30 - 20:00 first of our three polls for our audience uh the question we have is which of these costs is an indirect cost of insurance the poll will be open until all attendees have responded or 30 seconds uh whichever occurs first the options include a opportunity cost B fraudulent claim cost C morale Hazard cost or D frivolous lawsuit cost
• 20:00 - 20:30 and the results are in Rob it looks like
• 20:30 - 21:00 uh 75% of our attendee audience chose option a opportunity
• 21:00 - 21:30 cost yes thank you Marty uh this opportunity cost is the the correct Choice it's a it's a not a direct cost of insurance but it's a an indirect cost because if individuals or firms buy insurance they have funds tied up with an insured there's an alternative use for those and so uh that is what we would call an indirect cost associated with the with the insurance transaction uh the fraudulent claims costs morale Hazard and frous law cost those are just
• 21:30 - 22:00 costs associated with insurance those are going to be present depending upon the type of insurance uh no matter what the circumstance now we turn our attention to some uh fundamental uh Insurance principles uh and these are really important principles in terms of an insurer's ability to write insurance contracts these include the discussion of indemnification which of course is a variation on the word uh indemnify uh
• 22:00 - 22:30 there is something a statistical concept called The Law of large numbers and then there is a legal concept called um insurable interest so as we as I mentioned before insurance contracts are contracts of emnity and there's a fundamental principle that is that permeates all insurance contracts called the principle of Indemnity and basically this says that in the event of the loss that the insured that's the one part to the contract should basically uh lose
• 22:30 - 23:00 financially and so we should not be when we indemnify them uh we should not indemnify them more than what their loss is so as you can see here Insurance should not benefit an insure beyond the value of the loss so uh to give you an example suppose you had a five year five-year-old car and you were involved in an auto accident and it was total um and then you file a claim with your insurer insurer indemnifies you the question is how much should I indemn you um well I should not give you a
• 23:00 - 23:30 5-year-old car uh I should not give you a new car I should give you the value of 5-y old car uh if I gave you a new car uh then all of a sudden the the amount of amount I indemnify you is greater than the loss you had and this would want you to this would want you to cause losses to happen and so if you would be over indemnified or you would or you would you would U profit from a loss and this would violate um the principle of indentity saying that you should not profit from the loss and this would want
• 23:30 - 24:00 this would make you want to have losses or you you or you would exacer or you would uh exaggerate the amount of the loss so it increase the frequency or severity of the losses so what this basically does if we over empify you we've now made the moral hazard problem once much worse so one of the reasons why we have the principle of indentity uh is to control the moral hazard problem that I mentioned the next item is the law of large numbers uh clearly U insur insurance is unique in that uh insurers
• 24:00 - 24:30 have to make um forecast about the future um so what an insurance firm does is they they form risk pools as we'll see and they have uh various types of exposures or exposure units so they can been as cars or drivers or property in these u in these risk pools and they have to make a forecast or determination of future losses for the risk pool in total uh to do this is they use the law of large numbers which is a statistical
• 24:30 - 25:00 theorem um and the law of large numbers basically says that if you're going to use past information to predict the future which is what insurance firms do and you want to have accurate estimates about the future then you need a lot of uh past information to do so this is sometimes called uh the law of averages so if it weren't for the law of large numbers Insurance firms would not be able to sell contracts and indemnify their customers and notice that because of the law of large numbers uh the insurance coverage provided to you which you might think of is the face amount of
• 25:00 - 25:30 the contract is relatively large compared to the small premium that you pay and that uh that good outcome is the result of the law of large numbers one way to think about insurance is that insurance is a situation where uh individual losses become collectively predictable um and so what would be an unexpected loss for an individual becomes an expected loss they just predict with pretty high degree of accuracy in aggregate for for an insurer another important concept that that that
• 25:30 - 26:00 backs up insurance contracts is insurable interest and so anytime you have an insurance contract one thing the insurer is going to look for is does the is there an insurable interest present what that means is that the ins in the event of the loss the insured should lose financially or incur some other type of harm uh and so I give my students an example regarding insurable interest I tell them that I own home I tell them the name of my insurer I tell
• 26:00 - 26:30 them how much I pay for homeowners insurance and I tell them my insurance agent's name and phone number and I tell them that I'll give them an a if they can go out and insure my home by the next class of course they can't because none of them have an insurable interest in my home so if they could ensure my house if they could Ure an asset they did not have insurable interest in then of course they would want the loss to happen and they might collectively burn my house down uh to gain from that they would not suffer a loss they would gain
• 26:30 - 27:00 so notice that if that were the case they would be over indemnified and that would also create a moral hazard so you can see here that moral hazard is once again controlled by having and enforcing the insurable interest concept Insurance pricing is very different than pricing other types of goods or Commodities so you think about insurance pricing if I'm going to price any commodity I've have considered the cost of good sold um if I'm if I'm pricing an insurance contract um I know
• 27:00 - 27:30 some of my costs I have administrative costs I have salary of employees but my primary cost is losses because I or claims I have to I have to price a contract now I deliver it to you now it covers particular time period you may or may not have losses so part of the cost of good sold that I have are not known to me when I price it that's very unique in terms of pricing products U so basically what the cost of good sold for an insurer would be would be the claims or the losses whatever expenses or other
• 27:30 - 28:00 transactions cost they have perhaps an allowance for profit and then um this thing we call contingencies uh contingencies would be there to reflect the fact that we do have we do have to estimate future costs well thanks Rob and now we just like to take a moment uh for the audience to uh put some of this in context and the question we pose to do that is ask what do you think what issues affect insurance market
• 28:00 - 28:30 pricing so while you're considering that uh let's kind of go over some very Elementary issues that arise with with respect to pricing insurance contracts because remember you think about if I'm an insurance firm I have to price uh the insurance contract in terms of cost of good Soul what are my losses what are my expenses and then contingencies so there are some critical things that arise here uh something called adverse selection again we'll revisit Moral Moral Moral
• 28:30 - 29:00 and morale Hazard uh we'll also talk about Equity something called actual equity and social equity and then the timing here so adverse selection uh is a problem uh in Insurance markets uh so I'll give you a simple example here suppose I'm an auto insurer and I have an auto insurance contract I'm marketing to a set of customers and I think that all the people who are going to buy this contract are going to be what we call good risks for auto insurance very very healthy Drive and let's say I pric that coverage I
• 29:00 - 29:30 pric that insurance contract with that assumption in mind if however we'll take two cases if the people who actually buy the auto insurance are low-risk drivers or good drivers uh then that's good I price it accordingly if they are not lowrisk or high-risk drivers so high-risk individuals buy this insurance contract then that's a problem for me so in the selection process who is purchased and who hasn't the results adverse to the insurer so adverse selection basically
• 29:30 - 30:00 arises uh when you have high-risk people in your risk pool who are not necessarily paying high-risk premiums because they have not been identified as high risks U this is a real problem for insurance firms this is a problem that arises before the contract is issued so how does an insurance firm control the aders selection problem well they do it through a process known as underwriting so you go to an insurance firm you say I want to buy insurance the insur have to figure out what your level of risk is
• 30:00 - 30:30 you're transferring risk to them to do this insurers need information about the risk they need information about the risk that's being transferred to them about the insured about the Insurance's property about the insurance uh driving history Etc and so they need information information is key to controlling adverse selection so of course the question becomes sort of a public policy issue is well what information is relevant I mean there might be this information that the insurer has that's not relevant to that decision to assessing your level of risk and then how much information uh is too much uh
• 30:30 - 31:00 so there might be information that the insurer uh collect collects that may not be useful for that or it may be now with the with the rise of data analytics and Big Data Insurance firms are able to collect lots of information and by by having information about the risk insurers can have homogeneous risk pools as we'll see that's important and they're able to control the adver selection problem better if if insurers do not have information about the risk and they're not able to uh correctly classify Insurance uh then the insurance
• 31:00 - 31:30 Market breaks down the law of large numbers for example breaks down another another uh two items that we've already touched on morale and moral hazard uh so again these are behaviors that increase the frequency or severity moral hazard oftentimes is dishonest Behavior like insurance fraud but it's a more General change in Behavior Uh when insurance is present so again there there are cases where more Hazard imp dishonesty but it
• 31:30 - 32:00 doesn't always have to morale Hazard is just the fearlessness or indifference causing that now you do see a lot of insurance fraud for example uh in various types of automobile insurance uh there could be products liability general liability insurance there could be moral hazard issues there um it's moral hazard is always going to be present no matter what type of insurance you have uh a common way not the only way that ensures control moral hazard we've already seen that control it insurable interest and the EM requirement but they usually control it
• 32:00 - 32:30 by having deductibles in the contract so Insurance firms are very reluctant to provide insurance coverage which would fully indemnify their customers 100% coverage because then losses are free if you get deductible in a contract and if it's certain value losses are all of a sudden not free thanks Rob and we have arrived at our next poll question our question is what is the most common way to reduce moral and morale Hazard you will have 30
• 32:30 - 33:00 seconds to answer uh this question and the options include a avoid writing the policy B apply deductible in the policy C collect additional data about the risk D increase the premium to reflect the hazard if you haven't done so please take a
• 33:00 - 33:30 moment to select one of these options thanks Rob the results are in uh 86% of our attendees chose option b apply a deductible in the policy and that is that is the most common way to control moral hazard um one could argue quite successfully that collecting additional
• 33:30 - 34:00 data about the risk is a way to control moral hazard to the extent that moral hazard is related to uh insurance fraud uh but applying to dust is the most common way in which is controlled now we turn our attention to I think an important public policy issue uh actual Equity versus social Equity so uh in the underwriting process the the information collection process uh insurers collect information about the risk and they may they may have two
• 34:00 - 34:30 individuals who are buying the same insurance contract and they may charge them different rates for the same or different premiums for the same insurance contract so in a sense they are discriminating against them in other words they're treating them differently so the question is is that fair discrimination or is that unfair discrimination um so we have to think about well from an actual o perspective the more risk that you're transferring to an insur then what they should charge you for that so if you're so if you are really high-risk driver we should probably charge you more for auto
• 34:30 - 35:00 insurance than if you're a lowrisk driver so that we would say is example of fair discrimination um and that's really essential to Insurance pricing uh state laws of course uh do prohibit unfair discrimination in Insurance pricing so um state laws would say well we can't really charge uh different people auto insurance different rates of auto insurance based on their religion or based on the color of their hair uh so really when we talk about what is fair and unfair discrimination of course um
• 35:00 - 35:30 attendants would would vary widely on that perhaps um so actual rail Equity we can think of this as uh basically what a premium you pay has a very direct function to the level of risk that you're transferring to an insurer it's also called cost based pricing it's also called actual rail based pricing or what I like to call it risk based pricing so the more risk that you're transferring to me uh the more I should charge you for that now to figure out how much risk
• 35:30 - 36:00 are transferring to me I have to use risk classification variables and some some variables may be prohibited by state law a good example of a somewhat controversial uh risk classification variable could be gender rating um so some states are not allowed rates to be differentiated by by gender social Equity kind related to this social Equity says well pricing should be related to ability to pay and factors Beyond an insurance control like someone's gender uh should not affect
• 36:00 - 36:30 the premium so uh we don't really have a problem with charging high risk drivers more for auto insurance uh but we may have a problem charging One driver or another different premium based on their based on their gender timing is also important uh depending upon the type of insurance contract uh there's a maybe a long time period between when the premium is collected when the insured four event happens and when the losses actually paid so some types of losses are what we
• 36:30 - 37:00 call short tail losses so property insurance is a good example there I own I own a property it burns they comes they come adjust the claim they figure what the loss is going to be it settled and the property's rebuilt we're kind of done pretty quickly there but then there's some types of loss exposures that are longtailed losses so liability losses tend to be uh longtail because it may take a long time to determine the extent of the damage especially a property bodily injured when the CL when the case is settled
• 37:00 - 37:30 workers compensation losses could be longtailed someone is severely injured and the have to keep paying them so from an insurance firm perspective it makes forecasting the losses the ultimate losses more difficult the longer the tail is so there's there's more uncertainty involved there uh when there you when you have a longer tailed loss so now a good question to ask I think is well what is an ideally insurable risk in other words so some risks lend themselves toward being insured and some don't um there are six characteristics
• 37:30 - 38:00 uh of ideally insurable risk um some risks meet these characteristics ideally some don't if they don't meet them then um then there has to be something Ed to address the deficiency so for for example in the contract and insurers should only select those risks that meet the criteria if they don't if they don't follow these insurable risk guidelines then they have a possibility of becoming insolvent so the first these is is that if we're going to form risk pools there
• 38:00 - 38:30 should be a large quantity of similar people or objects that may be subject to a loss so we can say that the risk pool should be similar or homogeneous and so we can use the law of large numbers to correctly classify the risk and to predict the expected loss uh we need underwriting we need to be able to do risk classification to determine what risk pool someone exempt so if we don't use underwriting variables then we have risk pools that are heterogeneous risk pools and we are open to the possibility of having an adverse selection problem the loss should be fortuitous uh meaning
• 38:30 - 39:00 that the loss happens randomly but this also means there should be no moral hazard of course we know there is moral hazard but we already know how insurers can solve that problem uh the loss should not be catastrophic in nature to the insurer um so that we so one one event happening should not cause multiple losses to happen at the same time Insurance firms run the risk of bankruptcy when that occurs but insurers have access to reinsurance markets and that's one way to address that issue um
• 39:00 - 39:30 to the extent possible the time location and extent of the loss can be determined so the loss should be definite it should be determinable it's kind of hard to ensure losses if you can't if you can't tell where they've actually occurred uh the amount of the expected loss can be predicted so we have to be able to predict losses if we have a lot of estimation risk then Insurance becomes more expensive as a result of that and covering the loss expected losses economically feasible uh for the insurer so basically what what what this is
• 39:30 - 40:00 saying is that the insurance firm charges enough to be able to pay out the ultimate multimate loss should the should the loss happen now characteristics of the insurance product again there are some distinguishing features of insurance products that that are different from other types of products uh so three things that come to mind is one when you buy an insurance contract you pay all this money they give you paper or they give you a PDF document with your insurance contract on there and so it
• 40:00 - 40:30 really lacks a fiscal characteristic it's much more than the policy on paper and basically what you're buying is you're buying certainty and loss cost or you're buying a promise so in the event of the loss the insurance firm promises to pay uh a loss that you would otherwise be financially responsible for so again buying a promise I think is a critical part of what you buy when you buy an insurance contract okay thank you Rob going take a moment just food for thought for our
• 40:30 - 41:00 audience what do you think how does the complexity of the insurance product get in the way of consumer satisfaction and factors involved there might involve the notion that customers don't understand the terminology used and often do not understand the benefits provided by the policy or the way the policy works right so I suppose if you wanted to uh put yourself as sleep at night you might start reading it in insurance contract something that most people don't do uh so we'll note here that an
• 41:00 - 41:30 insurance policy contains very complicated terms and Concepts uh and notice that the buyer of insurance typically has no role in writing those contracts either it is a legal contract and it's such uh issues arise regarding claims and so forth that have to be settled in the courts uh perhaps by regulators and there may be be some legislation that is passed um in order to settle those those issues so it is a complex document um the benefits of having
• 41:30 - 42:00 Insurance uh are are not necessarily apparent to the to the buyer sort of deferred gratification a gratification that may never come right because you buy an insurance contract uh you're very glad you have insurance when an unfortunate circumstance arises uh when you have a loss so it's very different than uh buying food for example where you have a mediate gratification now we'll look at uh we kind of uh frame our discuss a little bit in terms of how how Insurance uh
• 42:00 - 42:30 fits in as a risk management technique for firms uh firms and individuals and organizations let's take a moment for another question for the audience to ponder what do you think what are some typical techniques people or companies use to manage risk and we can know that at one end of the risk Continuum is to retain or avoid loss exposures and at the other end is to transfer loss exposures to another party between the
• 42:30 - 43:00 two are various activities aimed at risk mitigation okay so we think about how a firm and individual manages risk so-called Risk Managers there are various tools available to them these are not mutually exclusive um so the first bullet and the last bullet really have something in common uh those are basically looking at okay if we have a loss of some kind who is going to pay for it uh if we retain that exposure to loss we pay for it if we transfer that
• 43:00 - 43:30 to third party someone else pays for it avoidance and control which would include loss prevention and loss reduction are what we call risk control techniques those are what someone might call proper risk management so for example there's a big difference between buying auto insurance as a way to manage your auto risk versus being a safer driver and inflating inflating your tires and not driving in the rain and wearing a seat belt those are all ways to manage the loss exposure itself those were all considered to be risk
• 43:30 - 44:00 management so one thing we might do as a firm an organization is we might retain the loss exposure and so what that means is in the event of a loss we will be financially responsible for it we're not going to transfer that to a third party um some loss exposures need to be need to be transferred some can be retained um it basically boils down to how predictable they are and if we can afford to pay for them themselves so one of the things that I always tell my students is if you have a lost exposure that you can predict with a high degree
• 44:00 - 44:30 of accuracy and you can afford to pay for it yourself then you should probably consider retaining that exposure loss um sometimes retention programs are viewed as deductibles that's part of retention and sometimes firms have what we call a formalized self-insurance program and that's also an example of retention some loss exposures are so severe we might we might consider avoiding those loss exposures so avoidance would be well we we cease to engage in an activity causing a loss or we never engage in
• 44:30 - 45:00 that activity causing a loss so um example not owning or driving an automobile eliminates potential Auto liability loss so so so you can avoid that by not participating the activity or if you're currently participating in it you stop you stop doing so avoidance is somewhat of an extreme measure we think of avoidance really being sort of the last uh ditch risk management solution in terms of those loss exposures that are higher frequency and higher severity a lot of firms getting
• 45:00 - 45:30 involved in controlling loss control mechanisms there are two two basic um examples here loss prevention for example uh with with respect to workers compensation losses reduces perhaps the frequency of injuries that happen we're trying to take steps to reduce the frequency so safety programs are training programs and then loss reduction reduces the severity of of losses so an example here fire losses right so having a fire extinguisher uh
• 45:30 - 46:00 is an example of a loss reduction doesn't prevent a fire from happening but once a fire does occur then it reduces the severity of that uh of course we may be involved in transferring Risk by what we mean here is we uh transfer financial responsibility of the loss that we would normally be responsible for we transfer that to someone else we might do it through a contract we might do it through lease agreements we might do it through hold Harless agreements but a very common example of a legal agreement where we're transferring financial responsibility of course is to buy an
• 46:00 - 46:30 insurance contract this is a very common way where we transfer financial responsibility to a third party and that third party is an insurance firm so one of the things that comes up is uh Insurance firms uh being regulated why are they regulated um I would say the short answer is that insurers are regulated for many of the same reasons that banks are regulated uh because they involve a lot of uh trusts uh so the classic reasons why we we posit that U
• 46:30 - 47:00 Insurance firm should be regulated is to protect consumers uh and to maintain insurance solv insurance solvency and to prevent destructive competition these are all sort of roll into one the basic reason why Insurance firms are regulated is to prevent insolvency consumer protection again we noted before that insurance contracts are complex legal documents uh most people don't have the uh interest for
• 47:00 - 47:30 example or perhaps the ability to read and understand an insurance contract buyers of insurance typically do not negotiate with insurers over terms of the contract especially in personalized insurance so it's felt that because of that's the case and because you're buying an intangible product the results of which you may not see for a long period of time if ever uh then regulating these insurance policies and products is important and also standardizing them too so if you're buying an auto insurance contract in the state of Pennsylvania it should look
• 47:30 - 48:00 like every other auto insurance contract in the state of Pennsylvania from whatever insurer you buy it from it's easier to compare apples to apples the products are standardized we also want to control Market conduct and prevent unfair Trade Practices so misrepresenting coverage to a particular insur insured refusing to pay claims those would be sort of bad Market conduct issues um and we also want to make sure that insurance is available and affordable especially if we have a situation where individuals are required
• 48:00 - 48:30 to purchase insurance so you kind of see this you've always seen this in the auto insurance Market I'm beginning to see this more at the state and the federal level in the health insurance Market since individuals have the the individual mandate now to buy health insurance um Insurance solvency regulation again what you have to think about is I give I give money to the insurer at one period of time they promis you pay my loss you happen at some future date if it's a longtailed loss exposure that future date could
• 48:30 - 49:00 keep coming and coming and and be a long period of time in the future so as a regulator we want to make sure that insurers are able to to honor that promise they're able to pay the claims they're they have first of all be in business to pay the claims and secondly they have to have enough money to pay those and pay them in a fair manner um imagine if you will a situation where insurers became insolvent people lost trust in insurance as a mechanism and so people would not buy insurance uh because they would not have uh they
• 49:00 - 49:30 would not have faith in the insurers ability to pay those losses and then um insurers hold short and long-term Investments and the security of these is really essential uh it's making sure that insurers are investing in safe assets uh so that when those assets are needed to pay claims they are in fact available we also want to prevent insurers from engaging in destructive competition competition is good but um we don't want a situation where insurers are competing for market share to get
• 49:30 - 50:00 market share they lower rates lowering rates is not necessarily a bad thing but lowering rates below what are needed to cover their costs would be a bad thing so they engage in sort of a a competition induced death spiral where they're basically selling products that that are they're selling at a loss if they do that constantly and continuously then Insurance firms will become insolvent um and or there will be an insurance shortage as a result as insurance firms uh pull out of the
• 50:00 - 50:30 marketplace thanks Rob and we've arrived at our third and final Poll for today's session this question regarding Insurance regulation Regulators seek to protect consumers by answer choices include a preventing fraud and unethical Market Behavior by insurers and producers B restricting availability of types of insurance view as unnecessary C eliminating all insure
• 50:30 - 51:00 insolvencies again you will have up to 30 seconds to complete this poll
• 51:00 - 51:30 the results are in 88% of our respondents chose a preventing fraud and
• 51:30 - 52:00 unethical Market behavior and Marty that is the correct answer uh even though it would be nice to eliminate all insur insolvencies that is possible to minimize insolvencies um insurers don't necessarily restrict the availability of types of insurance but they may guide Insurance firms as to what is appropriate in terms of contracts and pricing but preventing fraud and unethical Behavior by insurers producers um that's one way they they protect
• 52:00 - 52:30 consumers so to summarize our discussion today um we've noted that insurance is is a risk management technique that involves transfer of risk or financial responsibility to a third party called an insurance company insurance contracts by their very nature are complex legal documents that are supported by various principles and and and statistical Concepts um in the insurance Market transaction pre and post contract being
• 52:30 - 53:00 issued are affected by such issues as adverse selection which involves underwriting of course controlling moral and morale Hazard uh actual oil and social equity in terms of rate making and then the timing of the Lost payments and it's regulated to protect consumers and policy holders Rob thanks for that we have just a few moments left and in that time we do have a couple of questions uh first question is what
• 53:00 - 53:30 percent of Premium dollars get paid back as claims well that's a good question um that that's what what we would call a loss ratio so uh for every dollar I collect in premiums what percentage of that is going to pay out losses or claims as opposed to administrative cost or profit um it the answer is not 100% it's not it's not 100% of every dollar that an insurance firm collects supposed to pay out losses Insurance have expenses uh loss ratios do VAR widely
• 53:30 - 54:00 depending upon the type of insurance uh so for example if an insurance firm has 20% uh uh paid paid in expenses and profit then 80% would be paid out in losses uh so it does vary depending on the type of insurance the more competitive uh Insurance markets tend to tend to U have higher loss ratios uh higher loss rati is not necessarily a bad thing that's actually a measure of efficien of the insurance dollar being spent I will comment on the Affordable
• 54:00 - 54:30 Care Act uh it's part of part of legislation that ures depending upon what Marketplace they're involved in small group or larger Group market they have to maintain an 80 or 85% loss ratio thanks and we have one more question uh you had mentioned that the insurance premium covers the amount to pay losses plus loss adjustment expenses other overhead and profits so the question is how do most States handle excess insur
• 54:30 - 55:00 profits um that perhaps depends on how you define excess um but to the extent that that states and regulators and public policy officials are worried about that issue uh many states uh do regulate the rates that insurers can charge especially for types of insurance that are personalizes or are more more widely purchased uh by as opposed to business business insurance so Auto Insurance is a good example depending upon the state uh some states uh do have
• 55:00 - 55:30 rating laws prior approval laws and so forth that that really guard against uh excessive rates on the on the on the part of auto insurance in my example well Dr drenan thanks for those answers and thanks for joining us today and sharing your expertise with our audience thanks also to all of you who attended this session we appreciate your participation in our soft launch within a few days you will be be receiving an email message from us with a link to a post event survey please remember that
• 55:30 - 56:00 we need your feedback this is your opportunity to help shape the development of these new delivery options as a reminder this was the first webinar in a four-part series our next webinar will be on Tuesday July 8th at noon Eastern Time Dr David Eckles will present Insurance coverages Property and Casualty at noon on Monday July 21st Dr jenon returns with insurance coverages life and health our series
• 56:00 - 56:30 concludes on Monday August 11 at noon when Dr Eckles presents Insurance regulation and legislation you can register from links in the email we sent or simply visit wwwg Griffith foundation.org thanks again for joining us this concludes today's session