Business Insurance
Managing Risk
Chapter Two
Insurance is purchased as protection from possible losses resulting from perils that expose a company or individual to financial loss. Risk, hazard, and chance of loss tend to be used interchangeably, although each actually has a precise meaning. Even so, they are subject to varying usage within the insurance industry. In all cases, if it applies to a contract, the terms within the policy should be consulted.
What is risk? As it applies to insurance, risk is the uncertainty of loss (there will be variations of this definition, depending upon how it is applied). We do not know if we will have an auto accident, although we can take measures to prevent it by following all rules of the road. We do not know if our business will fail, although we can be careful by enforcing safety measures. We do not know if a storm will cause damage. These and many other factors bring about the need for insurance.
The uncertainty of loss contains two concepts: uncertainty and loss. Both concepts are important to insurance. Risk is the uncertainty - not the loss itself. The primary function of insurance is to handle risk.
Chance of loss is the long-run relative frequency of a loss. A fraction or percentage is most often used to state chance of loss. It indicates the probable number and severity of losses from a specified number of exposures. When it is expressed as a fraction, the probable number of losses is the numerator and the number of loss exposures is the denominator. How these numbers are expressed is based on certain factors. For example, if a coin is tossed there are only two possibilities: heads or tails. Therefore, there is a 50/50 chance that one or the other will come up (or a one in two chance). If we are choosing a number between one and ten, then there would be one chance out of ten that we would choose the correct number (or one in ten chances). This might be expressed as a possible loss in a couple of ways: 9/10 or 90 percent (there would be a 90% chance of loss).
Using fractions and percentages makes the chance of loss (or gain) easy to understand. However, how would one state the possibility of a fire or theft in such terms? Annalists are not likely to have specific figures to work with. While insurers do gather vast quantities of statistics, that still does not give them exact figures. Obviously, the insurer cannot know when a windstorm will develop or how severe it might be. The company may be able to predict, from past experience, but it would only be an indicator of the possibilities. The estimates will give loss frequency statistics, based on past windstorms. Loss severity figures are more important to the insurer because they indicate the amounts of claims that resulted.
Chances of loss figures are important to the insurance industry since they are the basis for setting premium rates. Therefore, they are equally important to the consumer who pays those rates. Because rates are dependent upon the frequency of loss it is very important that the statistics be accurate. An error could be financially critical to the insurer.
Chance of loss also is a major factor in the decision to accept or reject a risk. If the chance of loss is considered to be too high, the insurer will not cover the risk (reject the application).
Insurers must constantly consider the degree of risk. The term risk can have several meanings, but loosely defined it is the exposure to adversity or danger (that may or may not result in a loss). Mathematicians are interested in the behavior of phenomena and their definition of risk, which is the degree of dispersion of values around the mean (mean is the intermediate quantity). The larger the degree of dispersion, the greater the risk is. Even behavioral scientists measure risk as it relates to individuals and their actions.
Insurers look at risk from a financial standpoint: how often and how severe are the consequences of a specified circumstance? Even if the precise chance of loss were known, would it benefit insurers? Consider a known chance of fire as 1 in 1000. The insurer would conclusively know that one out a thousand buildings would experience a fire, but how would this help them? It does provide statistical information (loss frequency) but it does not tell them which building will burn. Will one of the buildings they insure burn or one that they do not insure? There is no way to know because there is no way to predict the outcome. Despite knowing the loss frequency there is still complete uncertainty. The only way to come closer to predicting the loss would be if one person owned 1000 buildings. Since the chance of loss is 1 in 1000, if the insurer did insure all 1000 of the individuals buildings, then it is likely that the insurance company will have a loss under that policy.
It is important to note that 1 in 1000 represents a low chance of loss. Even though it is not possible to predict the exact loss, the low chance of loss means the insurer will accept the risk.
When would 1 in 1000 represent a high risk? Suppose one person owned hundreds of stores all insured with the same insurance company. For example:
William Hodges owns 100,000 stores, which he insures with the same insurance company. Using the odds of 1 in 1000, the insurer can expect 100 of his stores to burn. Since these are not exact predictions it would be possible that as many as 110 or even 125 stores could burn. Of course, it is also possible that only 75 to 90 of Williams stores might catch fire. However, the insurer will consider the loss expectancy of 100 out of his 100,000 stores to suffer an insured loss. The large number of stores improves loss predictability, meaning it reduces the probable margin of error in predicted results. Therefore, since William owns so many stores, the degree of risk is reduced, even though the chance of loss remains at 1 in 1000. The risk cannot ever be entirely eliminated, even if William Hodges were to own a million stores. The probability always remains that losses will occur.
When we state that the degree of risk is reduced due to the larger number of stores William owns, what do we mean? What is the degree of risk? The accuracy with which losses can be predicted is the measure of degree of risk. It is a measurement by variation between the expected (probable) results and the actual results. So the insurer derives at their expected losses based on 1 in 1000, but the actual results may be higher or lower.
If the insurer knew for certain that 100 out of 1000 stores would burn there would be no uncertainty. The higher the measured number the more accurate the prediction. If 1000 stores are insured, the results of predicting 1 in 1000 will be more accurate than predicting losses based on ten stores. Using 100,000 stores brings even a higher degree of accuracy. The inability to predict accurately exactly what will happen is the point of insurance, of course. If William Hodges knew beforehand what losses to expect, he might be able to plan ahead and self-insure. It is the uncertainty of loss that makes insurance so important. The inability to specifically state losses makes insurers good scorekeepers. They must be able to accurately predict in order to set premiums. As events become more predictable for insurers their risk is reduced.
As we know, insurance is based upon contracts. The insurer agrees to specific duties and the insured promises full underwriting disclosure. Each contract outlines the others responsibilities. Because this is a legal contract, specific language is required.
We have looked at some definitions, such as risk. Some terms are commonly used, but not necessarily in the scope of insurance contracts.
A peril is the cause of the loss. Perils would include such things as fire, windstorm, explosion, collision, premature death, accidents, sickness, negligence, and even crime. These causes are often referred to as risks, but that is not technically true. Risk is the uncertainty that a loss will happen, not the cause of the loss.
The hazard is the cause of the peril. The fire that burns a building is the peril, but the boxes thrown near the furnace is the cause of the fire.
Boxes = Fire = Loss
Hazard = Peril = Risk
Hazards are often human-caused or at least could be eliminated with some human attention. While an investigation might reveal poor maintenance or improper housekeeping as the actual cause of the loss, for purposes of insurance, fire will be named. Fire is a covered peril, so the loss will be insured against.
The actual definition of hazard is a condition that may create or increase the chance of loss from a specified peril. Carelessness, poor housekeeping, improper maintenance, or anything that creates dangerous conditions are examples of hazards. Even a hole in a highway can be a hazard if it creates a peril that causes a loss.
There are two types of hazards: physical and moral. A physical hazard is a material condition increasing chance of loss. A moral hazard refers to individual human characteristics (usually of the insured) that increase the likelihood of loss. Arson is a common example of a moral hazard. Arson is committed for many reasons, but greed is probably at the top of the list. Another less recognized moral hazard is simple indifference to the possibility of loss. Our example of boxes piled near a furnace is a prime example of a moral hazard. If the insured is not concerned with safety because he or she knows there is insurance in place to cover a loss, simple preventive measures may be ignored. Indifference is often called morale hazard rather than moral hazard (note the e on the end of the word). Underwriters rarely make this differentiation since the result is the same regardless of the distinction. Moral hazards develop under a number of circumstances, but simple carelessness seems to be a primary one.
When an underwriter sees potential for moral hazards or a history of moral hazards the application is likely to be rejected. So, while fire may be listed as the peril, if investigation reveals carelessness as the hazard, this will be considered on future insurance applications.
Loss is the unintentional decline in or disappearance of value. It must be unintentional. An intentional cause changes everything about the loss. What does this mean? A gift of cash to ones child is certainly a disappearing value, but it is not unintentional (unless the child stole the money, which changes everything). When we become ill we must pay the doctors and perhaps even a hospital for our care. While the illness is unintentional, the paying of our bills is done intentionally in order to preserve our credit rating. Even though we pay our bills intentionally, because the illness was not intentional the definition of loss still applies.
We usually think of loss in terms of physical items, such as our car, our home, or our personal belongings. However, loss can also be an intangible one. This would be the case when value decreases, such as when business values plunge or common stock drops. Even technical obsolescence can be a value decrease with no physical item represented.
Losses caused by changing conditions in the market are called speculative losses. These are not usually insurable since they do not meet some of the criteria needed for insurable exposures. Pure losses are those where a physical article is damaged or destroyed, those caused by disability or death, those caused by outliving ones income, and those resulting from liability suits. These losses can generally be insured against.
Losses that are the result of property destruction include loss of the article, loss of its income or use, and extra expenses associated with the loss. Coverage for associated losses is vital for businesses since they must often set up at an alternative location or find other ways to conduct business when a loss interrupts their normal business functions. If the business owner has renters, he or she would also lose their rental income if a loss destroyed the building.
Business owners also carry coverage for negligence. Since negligence claims may be brought against the business for a number of reasons, it is important that sufficient coverage be purchased.
Insurance is absolutely necessary in the
Unfortunately for the businessman, thieves were everywhere. The thieves often considered stealing more honorable way of making a living than trading (again, some things dont seem to change very much). The result was that even honest salesmen could loose the goods to thieves. When this happened, he lost his property, including his wife and children, to the businessman who could then either keep them or sell them as slaves. Some claimed that the businessmen themselves were hiring thieves to steal their goods from the salesmen for a portion of the profits.
When it
became so bad that salesmen were routinely loosing everything to thieves (thus
all his personal belongings to the businessman) an alternative plan became necessary.
The salesmen rebelled, no longer willing to take on the risks personally.
A compromise was reached: they retained the former system with the additional
provision that in the event the caravan was robbed the salesman would be freed
from debt if he was innocent of conspiracy or negligence. This new
practice spread to
The Babylonians were not the only ones who needed insurance to make their work secure. The Greek bottomry contracts developed from the Babylonian idea. If a Greek ship-owner wanted to go on a voyage to bring cargo home from a foreign land, he would borrow the required money by pledging the ship as collateral. Sometimes the cargo would be pledged instead. When the cargo was pledged the contract was called respondentia. There was interest charged on these contracts, which included a sum in addition to that normally charged for a loan to compensate the lender for insuring the safety of the voyage. This additional amount was termed the premium, a word we still use today when a consideration is paid for insurance.
How
would the lenders and borrowers find each other? An exchange was
established in
It
wasnt just merchants who needed insuring. While no one knows when life
insurance was first written, we do know that a type of retirement insurance was
available in
In
early
The Romans adopted the burial aspect of the temple societies. The Romans, however, placed less emphasis on the religious element of the temple societies and opened them up to the general public. They developed a special society for soldiers providing death benefits and pensions for disability or old age.
There
are undoubtedly other examples of insurance used in ancient times.
However, the development of insurance as we use it today did not begin until
the 14th century with the chartering of an insurance company in
Marine
insurance was written at least in the 14th century and perhaps
longer ago than that. Early marine policies were not written by companies
but by merchants who wrote insurance as a sideline. The early policies
were mostly written in Italian although coverage was usually placed on English
ships and cargo. That was because most of the first policies came from
As
insurance began to be a full-time business rather than a part-time practice,
merchants were replaced by full-time insurance underwriters organized for
writing insurance and spreading information necessary to their business.
The coffeehouses of
A risk manager may be employed by large companies to supervise a large employee benefit department, according to The Life and Health Insurance Handbook.[1] Such a person is knowledgeable in group insurance and frequently has some type of applicable insurance background or education. The risk manager determines the feasibility of self-insurance, partial insurance with large deductibles, and full insurance as solutions to various coverage needs. Therefore, not only does this person make decisions as to which policies to buy from specific companies; they also decide whether to purchase insurance at all or opt to self-insure, in part or whole. When companies choose self-insurance that means they set up some type of system to absorb losses themselves. Todays tight economic circumstances have caused companies to look closer at how they insure the company itself and the employees they hire. Companies are more interested than ever before in alternative insurance options. When large companies self-insure they sometimes purchase administrative services, but seldom can they purchase risk-bearing services from insurance carriers. Small companies usually do not have the array of options that larger companies do. This puts small companies at a disadvantage in the insurance market. Sometimes multiple small companies that have a common thread choose to band together for their insurance needs.
Lets look at the marketing system of insurance. First, there is the need for insurance. This need is what fuels the sale of insurance products, whether it is individual health insurance, buy-sell agreements, or group disability coverage. Whatever the need, it fuels an insurance market if the need involves enough people or businesses.
An insurance need that involved only a handful of people would not bring about a policy that was priced low enough to sell well. Therefore, the need must involve enough buyers to bring the cost down to a viable amount (an amount that multiple purchasers would consider reasonable). The group buyer is very important because it means that a larger number of policyholders will exist. It affects all other components in the insurance field.
An individual insurance buyer often finds that cost is against him. That is why people try to find jobs that offer group medical, for example. There is more buying power in groups than there is for an individual. The entire marketing process focuses on the group buyer. This typically means an employer, a union, a group of trustees, a creditor, an association, or any group that has banded together for buying power.
Once a group is formed, their size will still affect the amount of buying power they have. Larger employers will have more buying power than small employers, for example. Small is typically considered a company with less than 500 employees, although this does vary from policy to policy. The number of insured people will always affect pricing.
In companies with more than 500 employees it is common for a person to be hired as a risk manager. In companies with less than 500 employees, the person making insurance decisions is usually a high-ranking executive.
Most large group buyers retain a broker or consultant to provide professional advise on their insurance needs. It may be a person who actually sells the insurance to the group or it may be an advisor who makes recommendations but does not actually sell the products. If an advisor is utilized, he or she is paid an hourly wage or some type of consulting fee. If the seller is actually an agent, their pay will come in the form of commission unless some other agreement has been made.
Whether an agent or an advisor, this persons responsibilities lie in plan design, administration and claim procedures, employee communications, financial considerations (premium amount), and regulatory requirements. A person directly hired by the company is more likely to focus on these elements than is the agent who is paid a commission from the insuring companies. Even an agent, however, must pay some attention to these elements in order to competently put together a quote for the company.
Some group sellers and advisors will focus on smaller companies while others will concentrate on larger groups. There are also those agents who sell the types of insurance offered by groups, but market the policies to individuals. An example of this is medical and dental insurance. While both may be sold to individuals, such policies perform best in a group-underwriting format. Those who sell to individuals seldom offer very much personal service. For the small amount of commission earned seldom can the agent afford to offer service.
The majority of group coverage is sold and handled by those that specialize in this market. Such firms put their entire focus on offering plans to businesses that have employees. The client relationship established by the group brokers and consultants enable them to keep and maintain business. The larger companies may even have former insurance company employees on their staff who have an inside knowledge of underwriting and insurer procedures. Their expertise provides a tremendous advantage over the individual who tries to dabble in such sales.
Independent and captive agents who work the group business sector are most
likely to deal with companies who have 100 or fewer employees. The larger
group agencies often do not want to invest their time in these smaller
companies. Therefore, those agents who specialize in small companies are
extremely important to our economy. Most of the job growth in
Many group insurance plans employ a group insurance administrator, often a third party, to handle the administration of established plans based on a fee basis. They are often found in the trust fund area involving both association and labor-management negotiated plans. Although the administrators duties can vary, typically they involve the collection of premium and remittance to the insurance company, handling the addition of new members, termination of members, claim and annuity payments, and fund accounting.
Non-industry individuals may not recognize the importance of many of the terms used in the insurance industry. The Buyers Guide to Business Insurance calls the term Risk Management an industry buzzword that can be confusing to the typical buyer. It is true that words from any type of business can become buzzwords that have multiple meanings. However, this is seldom true in such precise industries as insurance where each policy is a legal contract. Because the consumer may perceive insurance terms to be confusing, it is necessary that the insurance professional use language that is understandable. The art of communication is important for every person, but that is especially true of industries that deal with the consumers dollar.
Risk management is part of any business. The insurance industry has merely taken the initiative in defining it. Whether the business is a grocery store, an automotive shop or an insurance company, it is important that there be profit at the end of the fiscal year. For insurance companies, it is not only important that there be profit, it is mandatory because they must be prepared to pay out claims to their policyholders.
Business management is the process of determining how to balance costs and income. This is not surprising since it is business management that determines which factors cost money or bring in profit. For insurance companies, they must factor in risks when determining this because insurance is based on risk. To do this, they first identify the potential loss exposures of each type of business that they are considering. Some types of business will understandably be more risk prone than others. Once the risks are identified, the insurer must determine the level of loss that would be considered acceptable (while still allowing some margin of profit).
Insurance companies are not always correct in their initial analysis of the situation, but they are probably the best scorekeepers around. Since they will adjust their figures as needed, eventually insurers do know the potential loss for nearly any type of business concern. Risk management covers not only the possibility of tangible losses, but also intangible, such as business profits. Although any possible loss could be insured it would not necessarily be logical to insure. Risk management not only determines acceptable loss levels, they also determine whether a risk is worth insuring at all.
Businesses deal with the possibility of loss when they choose to buy insurance. Most will consider the obvious potential loss by fire, but there are many more that could be overlooked. Certainly it may not be possible (or even prudent) to pay for insurance to cover every conceivable loss, but owners must consider coverage for the elements that are most likely and would constitute a severe blow to the continuation of the company.
How does a business determine which losses will be severe? By looking at each step of their day-to-day activities. Would the loss of a particular person be severe? If so, what could be done to be prepared? Does the business need to train a backup for the position, purchase life insurance on the person, or consider alternative methods of business? As each element is examined, some of the solutions will involve the purchase of some type of insurance policy. While the purchase of insurance will not solve every problem, it will at least minimize some of them.
Some risks will merely need to be accepted while others must be addressed. Acceptable levels of risk are typically measured in dollars. There is really no other way to determine the level of acceptance. Even such things as down time of a business due to a catastrophe is at some point measured in dollars. Because they are measured in dollars, risk management is not a one-time evaluation. Risk management must be considered on an annual basis and when there is any major change in the business operation.
Obviously it is best to minimize risks that cause loss. If an owner realizes that he has had three employees injure themselves on the back steps that means that action must take place to correct the situation. Even though the companys insurance policy may be paying the costs associated with the injuries it would be unethical to allow additional injuries to occur. In addition, continued claims will lead to higher premiums or even a policy cancellation. Whatever the risk might be, minimization is important in any business operation.
Nearly every type of risk can be defined in some manner. The first step is to categorize the level of risk and the second step is to minimize the risk, if possible. The third step is to either insure the risk, if insurance is available for it, or to absorb the risk if insurance is either too costly in relation to the risk or the risk is small enough to be absorbed. Avoidance of the risk (minimization) is always a necessary step. However, avoidance of the risk or minimization of it does not mean the risk has been removed. Some risks remain for the business even with minimization efforts.
Insurance is the process of transferring risk from one party to another. Risk transference does not eliminate the need to minimize the risks or avoid them when possible. Chapter two of The Buyers Guide to Business Insurance states: Insurance is normally the most cost-effective and convenient method of transference of potential loss available to your business.[2]
When companies purchase insurance and then fail to continue to minimize or avoid the risks insured against it does eventually have an impact on their business, either as premium assessed or through policy availability. So, while insurance is one of the best transference methods, it does not relieve the company of their responsibilities.
The amount of risk transfer will depend upon a couple of factors:
1. How much the business can afford to pay in premiums, and
2. How much of the loss they are willing to absorb themselves.
While large companies may have a risk manager in-house to investigate and evaluate available insurers and policies, smaller companies tend to rely on the expertise of independent insurance agents. Agents often find themselves in competition with other agencies so price is nearly always a consideration. It should never be the primary consideration, however. While the company should not pay inflated prices, they will want to be sure that the benefits they require is actually purchased.
A business will not always have considered which losses could be tolerated and which losses would possibly be critical to their continued operation. Therefore, agents who work in the business field usually use some type of risk worksheet. While there is no standard form, it should contain a section in which to list the business risks, the probability of the risk, and the effect the loss would have on the continuation of the company. Obviously, if the probability of the risk is high and the loss that resulted would cripple the company it should be insured. The lesser risks will take more consideration with insuring it possibly being contingent upon the premium cost.
Worksheet Example:
|
Risks: 1. _________________________________________________ 2. _________________________________________________ 3. _________________________________________________
|
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Probability of occurring: High Above average Average Below average Low |
|
Business Effect: Severe Moderate Low |
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Premium Affordability: Affordable Possibly affordable Not affordable |
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Supplemental Information:
|
There are different types of worksheets that may be used. This is merely an example of one option.
Each business must identify potential loss exposures and set the acceptable level of loss for each aspect of the business operations. The term, risk management, is used as a general description of a variety of differing services available to those who purchase insurance products.
The types of loss a business faces will depend upon the business itself. For example, a grocery store might face different loss exposures than would a manufacturing company. That is why each business must identify potential loss exposures before they can buy a product to protect themselves from potential losses. Once loss exposures are identified it is important to also look at the different ways that the loss may be minimized or perhaps even eliminated. For example, if a potential loss exposure were based on boxes that are stacked along a stairway, obviously removal of the boxes would then eliminate the potential loss. Once a list of alternatives is developed, the businessperson must select the best alternative, whether that happens to be moving the boxes or insuring the potential loss. The result of the alternative should also be monitored to be sure the solution selected has been effective.
Usually there are four primary ways of dealing with a risk that would negatively affect a business: transfer the risk (purchase insurance), avoid the risk (move the boxes, for example), retain the risk (leave the boxes, and plan to pay any losses that result from company funds), or reduce the risk (move some of the boxes, leaving only those boxes on the stairway that pose the least risk). When the risk is retained, the business plans to pay the loss personally if it happens. When the business retains the risk they usually feel the potential loss is not severe and probably not one that would frequently happen. Therefore, the cost of the insurance may be larger than the cost of loss if an accident happens. The same is true when the option chosen is that of reducing the risk. In both cases (retaining the risk and reducing the risk), the business feels the type of risk is not likely to be financially severe or likely to happen often.
Risk Transfer
The value of insurance is the transfer of risk. Insurance is, in fact, often defined as the transfer of risk, although the legal definition is typically much more involved. Insurance allows an individual or a business to substitute a small, definite loss (the premium) for a large but uncertain loss if it meets the criteria set down by the policy. It is important to note that the premium paid is a certain loss. The individual or company knows it will lose this specified amount each month (or quarterly or yearly) as a routine expenditure. Therefore, it is a financial loss that is certain. In most cases, this expenditure will not be returned to the insured; it is a certain loss. In return for this certain loss, the insured gains the promise of transferring a much larger (though uncertain) loss to the insurance company. If no insured loss happens, the insurance company has gained the premiums paid without having to cover a claim. On the other hand, if a loss does happen the insurer pays the insured based on the language of the policy. It is the cookie jar effect:
Everyone with ten
cookies puts one of their ten cookies in a community cookie jar. If
When risk is transferred it usually means purchasing an insurance policy to cover the potential loss. This is often done when the risk is infrequent, but the potential loss is severe. In other words, the loss is not likely to happen often, but when it does happen the financial loss is great. A building fire is a good example of this. Fire does not occur frequently, but the loss produced by the fire is often great.
Businesses find that an insurance policy is one of the easiest ways to cover the potential loss because policies are usually affordable if the right coverage is available. Insurance packages usually cover accidental losses specific to each business. An agent is able to help guide the business owner through the steps to make the premiums affordable while still primarily covering the potential loss.
How does one decide what types of insurance are necessary while still keeping premiums affordable? The types of losses would be categorized using the previously shown worksheet.
When an individual handles a risk personally there is the chance of loss. In other words, where there is risk, there is also the chance of loss (in some circumstances, there may also be the chance of gain). There are some risks in life that must be retained because there is no way to shift the risk elsewhere. Sometimes retention of risk is simply the path of least resistance but risk may also be retained out of ignorance; the individual simply does not realize his or her alternatives. Many insurance policies are not purchased until a person meets with an agent who points out alternatives. Often a person does not even realize there is a risk present so they do not insure against it. Disability is a risk that should be insured against but often is not because people do not realize the potential of loss that exists.
Agents know why some risks may be retained: lack of action. The consumer understands the risk, understands how insurance will transfer the risk, but still does not purchase protection. We may not understand this inertia, but we certainly see it. Often protection is only purchased because an insurance agent knocks on the consumers door. The consumer may tell us that he or she had planned for some time to buy a policy, but just never got around to doing it. Most people probably do not experience a loss but for those who do, this inaction can be very costly financially. Agents seldom get credit for preventing such losses but we are likely to get blamed if we fail to place an appropriate product.
Many types of risk are retained simply because there is no way to shift it elsewhere. For example, a consumer would like to purchase a nursing home policy, but his or her health is so poor that no insurer will accept them. Therefore, it is not possible to shift the risk to an insurance company. This can be the case with many types of risk. In some cases, the risk is such that no policy exists to cover it.
Some risks are purposely retained. For example, most states have weight limits for trucks. If the states discover a truck is overloaded a fine will be levied. Despite this fact, many truck operators continue to overload because doing so is much more profitable. They are aware of the potential loss (fines), but choose to take this risk in hopes of financial gain (higher profits).
Americans also suffer losses because the loss is so small that no effort is made to avoid them. It may be ink pens that are carelessly left about, paper clips that are thrown away with trash rather than removing and reusing them, or food that is purchased but never eaten. Most people absorb some types of loss that could be avoided with planning or careful handling. Since these small losses do not bring a perceived financial burden, we do nothing to avoid them.
Most people avoid risk if possible. Of course, it is impossible to avoid all risks. Even going outside and crossing the street brings some degree of risk. Choosing lifestyles brings about risk as well. Those who smoke are risking cancer; those who live with smokers even assume a degree of health-related risk. Illness and other health related items associated with obesity cost employers millions of dollars every year in lost productivity and health care claims. Illegal drug use costs our society in many ways, including health care, crime, and even support for the families caught up in the cycle of abuse.
Some methods of avoiding risk do not seem sensible. The young man who never marries to avoid the risk of heartbreak is only denying himself the pleasure of loving companionship. The person who never drives a car to avoid mishap is depriving himself or herself of the ability to freely travel. Some alternatives to risk simply do not seem a prudent path. Even so, many of our daily choices do involve avoiding risk entirely. Those who never accept careers based on commissions are avoiding the difficulties associated with a non-guaranteed paycheck. By accepting only salaried positions the individual is avoiding the risk associated with commissioned sales.
It is important to realize that not all risks can be avoided. Avoidance is only possible if there is a choice between two or more alternatives. When risk cannot be avoided, it must be handled in some way.
Because most people are risk averters, risk can retard economic growth when new businesses or investors feel the existing risk is too great. The cost of social risk is separate from the costs associated with replacing or repairing property and is usually overlooked by the general consumer.
Risk can discourage investors and affects the allocation of resources. The companies that have little risk may receive greater access to resources while those that have high risk have difficulty receiving the resources necessary to their business activity. The effect becomes similar to socially undesirable monopolies. This affects production (if the resources are not available, production is limited), which then drives up costs for the goods or services affected. It should be noted that the cost is not the loss of capital resulting from the occurrence of an uncertain event, but rather the cost of that loss that is in addition to the cost of risk.
For Example:
A great adventurer thinks he has discovered dinosaurs on a lost island in the middle of the ocean. These are large dangerous beasts so even if the adventurer is correct, the risk to life and resources to obtain a specimen is extremely high. When the adventurer asks investors to give him money for his expedition those who fear risk will certainly tell him no. It will be very difficult to find any investor willing to risk their capital because (1) he hasnt proven the dinosaurs exist on the island (he hasnt even proven the island exists), and (2) even if they do exist, it will be very difficult to transfer one of them back to civilization where it may be sold at a profit. Any person or company that commits resources to the adventurers speculative investment is putting their funds at very high risk.
While the previous example has the sound of a movie script, there was an adventurer who committed to something very similar: Christopher Columbus. He was embarking on a trip to find a new trade route that he hoped would bring him and his investors wealth.
There are some risks that require government intervention (like Columbus and the Queen). When a risk is so great that it prevents needed capital investment, the government might pass legislation that artificially reduces the risk as a means of encouraging investment. The average American is not likely to realize such legislation has passed. For example, when our country was encouraging nuclear energy, it passed the Price-Anderson Act, which limited the aggregate liability resulting from a nuclear accident to a maximum of $560 million. This allowed the risk to be acceptable by investment standards, which increased investment in nuclear energy. The government has also sometimes accepted liability to encourage drug manufacturers to produce vaccines necessary for mass immunization (although it does not assume liability for cases of negligence or breach of contract with the government).
America strongly believes in suing one another, so there will always be liability associated with such things as vaccines, new medications, and other items that affect the public. In most cases, it is possible to obtain insurance to protect the business when a lawsuit is filed so it is not necessary to rely on government intervention.
As we have said, everything in life contains some amount of risk, whether it happens to be driving an automobile, investing in stocks, or even getting married. We tend to ignore most of the risks that surround us. We must in order to conduct our lives in a normal manner. However, there are some risks that we choose not to assume. When this is the case we must find a way to avoid the risk. What we do will depend to some extent upon the risk involved:
1. Avoid the specific risk entirely (if this is possible).
2. Retain the risk.
3. Reduce the hazard.
4. Reduce the loss from the risk through some measure.
5. Shift the risk, usually through the purchase of an insurance policy.
6. Reduce the risk if possible.
It is important to remember that risk and hazard are different so while some of these possibilities seem the same, they are not. Risk, for insurance purposes, is defined as uncertainty as to a financial loss whereas hazard defined as a condition that may create or increase the chance of loss arising from a peril. A peril is the cause of the loss.
In the case of our adventurer, the risk is the uncertainty of whether there will be a profit made on his search for the dinosaur or loss of investment funds. The hazard could include many things, such as carelessness on the part of the adventurer, poor organization on the trip, or dangerous actions on the part of the crew. Perils would include the dinosaurs (if they exist) as well as weather conditions, island terrain, and even sickness or death of those involved. Peril and hazard are often used interchangeably, although there is a distinction between the two. Hazards are conditions, such as carelessness and dangerous employments; perils are causes, such as fire, windstorm, explosion, premature death, accidents, or sickness.[3]
Every insurance agent dreads hearing: I am insurance poor and I never have any claims. Consumers often feel they pay out hundreds of dollars each year without needing the coverage. Unfortunately, this can lead to a false sense of the existing risks. The business executive may feel that he or she can let some type of insurance lapse or reduce benefits in the belief that it will not be needed. A company that has continued to pay for fire insurance, without ever suffering such a loss, may feel that they can reduce the amount of coverage they carry. An individual who has never had an automobile accident may begin to feel a false sense of security. At some point the business executive or individual may decide to self-insure. That is, the business or person absorbs any losses that would have otherwise been covered by a policy.
Some businesses or individuals may begin a fund for losses, often depositing the amount that would have otherwise been spent on premiums. Some may even put more than the amount that would have been spent on premiums. The idea is to have the money set aside in case a loss happens. If no loss occurs, then the company or person still has the amount available that would have been spent. In some cases it may work, but in others it is not advisable.
For example:
Ralph owns a shoe store. After five years of paying fire premiums he decides to self-insure. Ralph immediately begins putting the amount of his fire premiums into a separate fund. Three years later his store burns down. Ralph has saved $20,000 in the fund (the amount he would have paid in premiums) but unfortunately the loss of the building and contents amounts to $250,000. In this case, Ralphs decision to self-insure was not appropriate for the amount at risk.
There are cases where self-insurance may be appropriate. For example:
A national chain of shoe stores self-insures. Because there are so many stores involved, the combined savings of premium put into an account may be adequate if one or two of the stores burn. Of course, there is still the danger that a bad year may produce more losses than planned for. The primary problem for the store chain, even with hundreds of stores nationwide, is the ability to predict losses and adequately plan for them. If many of their stores happen to be in an area that experiences a tornado, for example, a single event may wipe out their fund and leave then inadequately funded.
Whether or not insurance is carried, it is always wise to reduce hazards when possible. Much loss-prevention research is conducted or financed by insurers. Certainly it is to their benefit to prevent losses from happening in the first place. Those that self-insure should also do everything possible to prevent losses.
The cost of losses is an important factor and is distinguishable from the cost of risk.[4] The cost of the risk is determined before the loss actually takes place. This is how insurers price their policies. Cost-of-risk is connected to loss-control expenditures (such as fire extinguishers, fire alarms, good auto construction, and so forth). Budgeting funds for before-the-loss expenditures can reduce the actual cost of the loss because the loss may be reduced as a result of the preparations made. Building a loss fund would also be considered part of the cost-of-risk since the funds are set aside and not used for other purposes. Even though the funds are not available for other purposes, the cost is considered to be less because funds are available immediately to offset a loss. Cost-of-loss involves the actual loss itself after it has taken place.
Risk managers are highly involved with controlling losses. They realize the importance of safety measures and other means to prevent or reduce loss. Loss control may require a variety of trained people, such as loss control engineers, accountancy systems analysts, attorneys, or industry specialists. Loss cannot be controlled unless everyone at the company understands its importance and follows proper safety procedures. The man that takes out the trash that would otherwise be stacked against the building is just as important in preventing losses as is the engineer that sets up the machinery. Each person associated with the business must do what is necessary to maintain safe operating standards if losses are to be prevented or reduced.
As we know there is a difference between a hazard and a loss. Reducing hazards, such as trash stacked against the building, can prevent the loss in the first place. Once the loss has happened, however, there are still measures that can be taken to reduce it. A sprinkler system installed in the building may minimize losses if a fire begins, for example. Without the sprinkler system the entire building may be lost, whereas with the sprinklers only the room where the fire originates may be damaged. Besides reducing the actual loss, such safety measures may also reduce the premium rate paid for insurance policies. This is not surprising since insurers certainly recognize the benefit of such systems.
The purpose of an insurance policy is to provide indemnity. Indemnity is compensation or remuneration for loss or injury sustained. It is seldom the intent of insurance to provide financial gain, so policies limit payments to the amount of loss subject to policy limits. In other words, even if Sally has her house insured for $200,000 and sustains a loss of $50,000 only the actual amount of loss ($50,000) would be received under the terms of her insurance policy.
Sally sells her house. If Sally fails to cancel the $200,000 policy and the house burns down, Sally would not receive any payment because she would not suffer financially having already sold it. Policies are designed to offset a loss, so of course a loss must actually exist.
Insurance is often compared to gambling: the insurance company is gambling that no loss will happen (so they gain the premiums paid) while the insured is gambling that a loss might happen (so the policy will pay benefits often much higher than the premiums paid in). Actually the use of indemnity is the only legitimate use for insurance, preventing it from being a gambling situation. In gambling the risk is created by the transaction whereas in insurance the risk is reduced by the transaction.
For example:
Robert goes to the racetrack. Merely being at the track and watching the horses run produces no risk. It is not until he places a bet that a risk is created (he may either win or lose). The risk is created by the transaction of placing a bet.
Under insurance, the risk of loss to property by fire or some other peril is present until reduced or eliminated by insurance. The risk is reduced by the transaction of purchasing an insurance policy.
We often think of risk in terms of our own losses, but insurance companies face losses, too. For example, a potential small underwriting profit for property-casualty companies in 2003 was wiped away by Florida hurricane damages experienced in 2004 for the third largest commercial insurance line commercial multiple peril (CMP). There is little doubt that writing multi-peril contracts effectively address the insurance needs of commercial policyholders. Steven Pozzi, chief underwriting officer for Chubb Commercial Insurance, stated: It would be a mistake not to understand that multiple peril insurance is the hub around which the spokes of umbrella, workers compensation and auto are placed.[5] Packaged policies contained more profits for insurers in recent years as well. Despite the Florida hurricanes, multi-peril packages work well for insurers.
2004 was the fourth-straight year in which package results were better than monoline liability and property totals, according to an analysis prepared using data from National Underwriter Insurance Data services. NU combined net premiums, losses and expenses for the fire, allied, inland, earthquake and burglary lines to derive loss ratio and combined ratio results, which are referred to as monoline property results.
Several facts emerged from this study.
For the seven years NU reviewed, monoline property loss ratios were always better than package policy property results. However, the gap between monoline and CMP property started to close in 2001. That was due to substantial property loss ratios improvements, whether written in a package or not.
Monoline liability had worse loss ratios than CMP liability for the most recent five years.
Since liability differentials are greater putting property and liability results together, CMP loss ratios are now consistently better than monoline loss ratios.
For combined ratios, the expense component of monoline combined ratios tends to be lower than CMP expense ratios. As a result, combined ratios for package polices are consistently worse than monoline policy combined ratios.
Much of the commercial multiple peril is due to business owners policies. During the post-2000 period, pricing on smaller, less complex accounts saw less increase than did the larger accounts, due in part to the competition in the small commercial market.
Thank you,
United Insurance Educators, Inc.
End of Chapter Two