Fundamentals of Risk and Insurance, 11th Edition Solution Manual

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SECTION ACHAPTER NOTES AND ANSWERS TOEND-OF-CHAPTER QUESTIONS- 9 -

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SECTION IRISK AND INSURANCEThis first section of the book introduces the student to the basic principles of insurance.Chapters 1, 2, 3, and 4 deal with the subjects of risk, insurance, and risk management.Thediscussion of risk management is divided into two chapters, the first providing a generaloverview of risk management and the second deals with risk management decisions andspecific risk management applications.Chapters 5, 7 and 8 treat institutional aspects of insurance, describing the various typesof insurers, the manner in which they operate, their distribution systems, and some of theunique functions of insurers.Chapter 6 describes the regulation of the insurance industry.It traces the historicaldevelopment of insurance regulation and describes current regulatory practices.It alsodiscusses the issues related to the debate over state versus federal regulation.Chapter 9 discusses the law of contracts and other important legal principles associatedwith private insurance contracts.In our opinion, the critical chapters in this section are Chapters 1, 2, 3, 4, 5, 6 and 9. Webelieve that the material in these seven chapters should be covered in every course.Theremaining two chapters may be covered as time permits. We consider Chapters 7 to be next inorder of importance, and rank Chapter 8 last.- 10 -

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CHAPTER 1THE PROBLEM OF RISKGeneral Comments on the ChapterA discussion of risk—the basic problem with which insurance deals—logically precedes thediscussion of insurance itself. This chapter introduces the concept of risk, defines it, and discussesthe distinctions that can be drawn among the different classifications of risk.The definition of risk used in the text evolved over a period of many years, and grew out of apersonal dissatisfaction with the definitions used in other books.It has always seemed to us thatthe definition of risk in an insurance course should immediately suggest to the reader the basicproblem insurance is designed to solve, and that risk should not be a concept treated in the firstchapter and then forgotten for the remainder of the book.Most people immediately recognize a situation in which a loss may occur as the basic reasonfor buying insurance. In simplest terms, risk is defined as aconditionin which a possibility of lossexists.More specifically, risk is "...aconditionin which there is a possibility of an adversedeviation from a desired outcome that is expected or hoped for."Defining risk as "a condition"seems to us to be both semantically and intuitively appropriate.It delineates the essence of thething being defined and helps to emphasize the notion that risk is a state of the world created by acombination of circumstances.In addition, it more or less coincides with the intuitive notion ofrisk.Risk can exist (as a condition of the real world) even when the danger is not perceived andwhen there is no uncertainty.Uncertainty can exist in situations where there is no risk (that is,where the possibility of loss does not exist).In addition to establishing a formal definition of risk, the chapter stresses the distinctionsamong the various subclassifications into which risk may be divided.We believe that the mostimportant of these are the "fundamental-particular" and the "pure-speculative" distinctions.Thediscussion of fundamental and particular risk is a convenient time to consider terrorism risk andthe merits of the federal terrorism reinsurance program that was created following the terroristattack on the World Trade Center.Some time should also be spent in distinguishing among theterms "risk," "peril," and "hazard," and in differentiating among the classes of hazard.This edition includes a discussion of “systemic risk,” reflecting the increased attention givento the concept in the aftermath of the recent financial crisis.The focus of this course is not onsystemic risk, its cause, and the regulatory response, but it seems reasonable for students to havesome exposure to the concept.In our experience, students are interested in learning about thefinancial crisis and its onset. Thus, the instructor may choose to take a brief detour to discuss AIGanditsroleinthecrisis.Asimpleexplanationinvideoformisprovidedathttp://www.youtube.com/watch?v=DdEI6PkGZK8.Alternatively, the instructor may prefer todefer the discussion to chapter 6, when the regulatory response is also presented.Because thevideo refers to credit default swaps as insurance, this is also an opportunity to discuss the thedifferences between insurance and credit default swaps, and the fact that AIG’s difficulty was notits traditional insurance business.This discussion is likely to be more clear to students after theyhave completed chapter 3, The Insurance Device.- 11 -

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The evolving nature of risk can often be illustrated with current events. Cyber risk is one areathat is often in the news (As this is being written, Target is in the news for a cyber security loss, inwhich the credit and debit card information of up to 40 million customers was stolen in lateNovember and early December 2013.The case is an excellent example of both cyber risk andreputational risk.)The section entitled The Burden of Risk explains why risk is a problem and briefly notes someof the detrimental aspects of risk. In discussing the burden or risk, we stress the dual-faceted natureof the burden; first, the costs associated with the losses that will actually occur, and second, the costsassociated with the uncertainty regarding who and what will suffer loss.The uncertainty associatedwith risk creates the need to accumulate a reserve for contingencies (which involves an opportunitycost), deters capital accumulation, increases the cost of capital, and results in anxiety and worry.Important Concepts to be StressedThe most important concepts in the chapter, and the principles that we believe should bestressed in the lecture are:•The definition of risk as a state of the real world•The degree of risk•Risk distinguished from peril and hazard•Classification of hazards as physical, moral, and morale•The distinction between static and dynamic risks•The distinction between fundamental and particular risk•The distinction between pure and speculative risk•The concept of systemic risk•Classifications of pure risk•The burden of risk•The increasing frequency and severity of lossesAnswers to Questions for Review1.Risk is defined as a condition in which there is the possibility of an adverse deviation from adesired outcome that is expected or hoped for. In simpler terms, it is the possibility of loss. Riskis a state of the real world in which a possibility of loss exists, while uncertainty is a state of mindcharacterized by doubt or a lack of knowledge about the outcome of an event. Risk can exist (as astate of the real world) even when the danger is not perceived and where there is therefore nouncertainty. Uncertainty can exist where there is no risk. See pages 2-3.2.Riskmaybesubclassifiedasdynamicorstatic,fundamentalorparticular,pureorspeculative, and systemic or nonsystemic.The distinguishing characteristics of each class arediscussed in pages 6 and 7 of the text.Dynamic risks are those that arise from changes in theeconomy; static risks would exist even in the absence of economic change. Fundamental risks arethose that are impersonal in origin and consequences—they are generally beyond the control of theindividual. Particular risks are personal in origin and consequence, and are generally considered tobe the individual's own responsibility. Pure risks are those in which there is a chance of loss or noloss only.Speculative risks involve the chance of loss or gain.Systemic risks affect an entiresystem and could cause cascading effects that disrupt other institutions.- 12 -

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

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9.The number of risk increases over time because with changes in technology, new causes ofloss and new hazards emerge.(See pages 8-10.) The text cites the transition from muscle, windand waterpower to steam to electric to nuclear power and the increase range of perils as anillustration of this phenomenon.The development of new legal theories and rights also createrisks, as has the transition to the information age.Cyber risk, in particular, is an increasinglyimportant problem for individuals and society.10.Earthquake - peril; sickness - both a peril and a hazard; worry - hazard, careless act -hazard; economic depression - hazard. The principal focus in discussing this question should be onthe distinguishing characteristics of perils and hazards.A peril causes financial loss; a hazardincreases the likelihood that a loss may occur from a peril. Thus, sickness is a peril that can causeloss of income, but it is also a hazard that can increase the likelihood of death.Careless acts andeconomic depressions are hazards that create the chance that economic loss may result from alawsuit or from unemployment respectively.Answers to Questions for Discussion1.Students' answers will vary, depending on the concept of risk that they hold. For those whodefine risk as uncertainty, there is clearly uncertainty in this situation, and the uncertainty withrespect to the outcome of a past event constitutes risk to the same extent as would uncertaintyregarding the outcome of a future event.Conversely, for the students who accept the text'sdefinition of risk (as a condition in which the possibility of loss exists) risk does not exist in thissituation because the outcome for both Tom and Tim is certain.2.Mike's statement is true. For the individual, the possibility that the house may be destroyedby fire is a pure risk, because the possible outcomes include only fire or no fire.For the insurerthat engages in the business of accepting the risks of individuals in return for a premium payment,the single exposure unit and the aggregate of all of the houses insured constitutes speculative risk.3.In the case of gambling, as in the case of other speculative risks, the possibility of gain is thebalancing factor.The gambler may also find the possibility of losing distasteful, but he or sheincurs that possibility because it carries with it the possibility of a gain that is attractive.Inaddition, some would argue that it is not necessarily true that all people find risk distasteful; forsome people it may be a delightful experience.One could conclude, however, that all forms ofpure risk are distasteful, whereas risks of a speculative nature find favor among many people, andit is the possibility of gain that accounts for this difference.4.Students answers will differ, but in general they should follow the pattern suggested by thefour-fold classification discussed on pages 7-8 of the text (personal risks, property risks, liabilityrisks and risks arising out of human failure).5.Students answers may differ, but it may be expected that the students would find the 5%chance of losing $1,000 more distasteful than 50% chance of losing $100. This question providesan opportunity to discuss the concept of marginal utility, and also the critical role of severity indetermining the importance of risks.- 14 -

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CHAPTER 2INTRODUCTION TO RISK MANAGEMENTGeneral Comments on the ChapterPrior to the ninth edition of the book, we deferred the discussion of risk management until thethird chapter, after a discussion of insurance and how it works was introduced in the secondchapter.We thought that an understanding of insurance and how it operates provided usefulbackground for understanding why risk management represented an important break with the past.After 30 years, we came to share the opinion of those who prefer to introduce risk managementbefore turning to the subject of insurance.Although this text is intended to focus primarily on pure risk, the increasing popularity ofenterprise risk management cannot be ignored.The text distinguishes between enterprise riskmanagement, financial risk management, and traditional risk management.Concepts such asmarket risk, credit risk, liquidity risk, and operational risk are discussed briefly. Finally, the text’sdefinition ofrisk managementisno longerlimited to the managementofpure risks, butencompassesmanagementofallrisks.Note,however,thatwemaintainafocusonthemanagement of pure risk in the remainder of the book.For example, the discussion of the role ofthe risk manager toward the end of the chapter focuses on traditional risk management – themanagement of pure risk.In discussing the evolution of risk management, the text follows the conventional explanationthat risk management evolved from the field of corporate insurance buying, but goes further andattempts to explainwhyrisk management emerged when it did. We believe that the appearance ofrisk management as an academic discipline owes much to the introduction of operations researchand management science into the business college curriculum.The evolution of risk managementwas not inevitable, but required some external stimulus.Prior to the introduction of decisiontheory and the spread of its effect to other disciplines, little attention was devoted to the quality ofrisk management decisions.The insurance manager’s job was to buy insurance, and he or shewould rarely be criticized for doing so.The real threat to an insurance buyer’s career was theuninsured loss and insurance buyers protected themselves as well as the corporation by buyingmore, rather than less insurance. Although some may disagree with the emphasis on the changes indecision making generally as the basis for risk management, we find no other explanation for theemergence of our discipline.In discussing the tools (techniques) of risk management, we have used the traditionalterminologyinclassifyingriskmanagementtechniquesasriskcontrol,whichfocusesonminimizing the risk of loss to which the organization is exposed, and risk financing, whichconcentrates on arranging the availability of funds to meet the losses that do occur. Although someinstructors may prefer one of the more detailed approaches to classifying risk control and riskfinancing techniques, we have adopted the following classification systemRisk ControlRisk FinancingAvoidanceRetentionReductionTransfer- 15 -

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In this scheme, risk sharing is viewed as a special case of risk transfer, in which the risk istransferred from the individual from the group. (It may also be a form of risk retention, dependingon the success of the risk sharing arrangement).The final section of the chapter is a brief discussion of the risk management process.Although most of the material in this section is similar to standard treatments of this subject, thereare some differences.One is the addition of "Determination of Objectives" as the first step in therisk management process. We believe that this focus on planning and objectives adds a managerialemphasis that is otherwise lacking.Another area that we prefer to address early in the course is what we have termed in the textthe two misconceptions about risk management. The first is that the risk management concept isapplicable principally to large organizations.The second is that the risk management approach todealing with pure risks seeks to minimize the role of insurance. The first misconception—that riskmanagement is concerned exclusively with the problems of giant organizations—arose becausemuch of the early literature in the field came from insurance buyers in giant organizations andaddressed the problems with which they were concerned. With respect to the notion that insuranceseeks to minimize the role of insurance, the argument is semantic. In the sense that insurance is alast resort, it can be argued that risk management does relegate insurance to a different role thanpreviously. On the other hand, there are cases in which insurance is the most effective and suitabletool for addressing risk.Important Concepts to be StressedThe most important concepts in the chapter, and the principles that we believe should bestressed in the lecture are:•The development of risk management•The distinctions between enterprise risk management, financial risk management, andtraditional risk management•The revision of business college curricula and decision theory•Decision theory, risk financing and risk control as elements of risk management•The distinction between risk management and insurance management•The steps in the risk management process•The nonprofessional risk manager•Risk management and the IndividualAnswers to Questions for Review1.The three specialties that are merged in risk management are decision theory, risk financing,and risk control.Decision theory has its roots in operations research and management science.The risk-financing specialty came from the disciplines of finance and insurance, and the riskcontrol specialty represents the merger of traditional safety management and loss prevention, asdeveloped by the insurance industry, and systems safety from the military and aerospace industry.See page 15.2.The two broad approaches to dealing with risk recognized by modern risk managementtheory are risk control and risk financing.Risk control focuses on minimizing the risk of loss towhich the firm is exposed, and includes the techniques of Avoidance and Reduction.Risk- 16 -

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financing concentrates on arranging the availability of funds to meet losses arising from the risksthat remain after the application of risk control techniques, and includes the tools of Retention andTransfer. See pages 17-20.3.The four basic techniques available to the risk manager for dealing with the risks areavoidance, reduction, retention, and transfer.Avoidance and reduction are risk control techniques,while retention and transfer are risk financing techniques.Risks are reduced to the extent possiblethrough avoidance and reduction; what remains after risk control efforts are implemented must befinanced. The choices are retention or transfer, collectively exhaustive and mutually exclusive. Whatis not transferred is, by definition, retained. See pages 17-20.As noted in footnote 12 on page 20, some writers include a fifth technique, sharing.Webelieve that risk sharing is actually a special variation of risk transfer (and sometimes retention). Inrisk sharing, risk is transferred from the individual to a group, where it is shared, but it is transferfrom the perspective of the transferor.For the members of the group collectively, sharing isactually a form of retention.4.The change in philosophy that marked the transition from insurance management to riskmanagement occurred when the attitude toward insurance changed.For the insurance manager,insurance had always been the standard accepted approach to dealing with risks.The insurancemanager viewed insurance as the accepted norm or standard approach to dealing with risk, andretention was viewed as an exception to this standard. The insurance manager contemplates his orher insurance program and asks "are there any risks that I should retain?" "How much will I savein insurance costs if I retain them?"In viewing loss prevention measures, the insurance managerasks, "How much will this measure reduce my insurance costs?" "How long will it take for a newsprinkler system to pay for itself in reduced fire insurance premiums?" Rather than asking, "whichrisks should I retain?" the risk manager asks, "which risks must I insure?"The difference isobviously one of emphasis.The insurance-management philosophy views insurance as theaccepted norm, and retention or non-insurance must be justified by a premium reduction that is, insome sense or another, "big enough." The risk manager, in contrast, views insurance as simply oneof several approaches to dealing with pure risks.Under the risk management philosophy, it isinsurance that must be justified.Since the cost of insurance must generally exceed the averagelosses of those who are insured, the risk manager believes that insurance is a last resort, and shouldbe used only when necessary.5.The six steps in the risk management process are:(1)Determination of objectives, (2)Identification of risks, (3)Evaluation of risks, (4)Consideration of alternatives and selection ofthe risk treatment device, (5) Implementation of the decision, and (6) Evaluation and review.Seepage 24.6.Risk management evolved from insurance management.The primary motivation for thecreation of insurance departments and insurance managers was the increasing cost of insurance.The evolution of decision theory and operations researchled to a more widespread acceptance ofthe scientific approach to decision making and especially decision making under conditions ofuncertainty. Prior to the development of the decision-theory models, there was a tendency to judgedecisions under conditions of uncertainty based on whether the decision turned out to berightorwrongin some after-the-fact sense.Decision theory provides a basis for judging the goodness orbadness of decisions before the outcome is known.- 17 -

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The transition frominsurance managementtorisk managementoccurred over a period oftime, and paralleled the development of the academic discipline of risk management. It is not clearwhether the academic discipline led or followed, because developments in the corporate sector andthe academic world appear to have occurred simultaneously.It is an exaggeration to suggest thatrisk management originated in the academic world.It grew from a merger of engineeringapplications in the military and aerospace programs, financial theory, and insurance. Many of theconcepts of modern risk management that originated in academic halls, however, were taken overand applied in the corporate world. See pages 13-15.7.The actual responsibility of the risk manager varies depending on the organization. Some riskmanagers have overall responsibility for all risk control and risk financing activities, including thefirm’s employee benefit plan. In other cases, various parts of the risk control function, for example,may be assigned to a director of safety or a security director. Most risk managers are located in thefinance department, but some may be found in a personnel or production division. There is a trendtoward risk managers reporting to an executive vice president or even president. Page 22 - 23.8.As noted in the text, the terms "insurance manager" and "risk manager" are often usedinterchangeably, without a great deal of attention to the actual role of the individual.One featurethat distinguishes risk management from insurance management is the type of risks that eachaddresses.Because risk management evolved from insurance management, it is concernedprimarilywithinsurablerisk.Although the major focus of most risk managers is on insurablerisks, the more appropriate realm of risk management ispurerisk.In other words, the riskmanager cannot ignore those pure risks that are not insurable. The text cites shoplifting losses as atype of loss that is rarely insurable, but with which the risk manager should be concerned.Riskmanagement is, therefore, broader than insurance management, in that it deals with both insurableand uninsurable risks.Riskmanagementalsodiffersfrominsurancemanagementinphilosophy.Insurancemanagement involves techniques other than insurance, but in general these other techniques areconsidered primarily as alternatives to insurance.Under the risk management philosophy,insurance is viewed as simply one of several approaches for dealing with the pure risks the firmfaces. Whereas the insurance manager views insurance as the accepted norm or standard approachto dealing with risk, and retention is viewed as an exception to this standard. The risk manager, incontrast, views insurance as simply one of several approaches to dealing with pure risks.Ratherthan asking, "which risks should I retain?" the risk manager asks, "which risks must I insure?" Thedifference is one of emphasis.The insurance-management philosophy views insurance as theaccepted norm, and retention or non-insurance must be justified by a premium reduction that is, insome sense or another, "big enough."Under the risk management philosophy, it is insurance thatmust be justified. See pages 20-21.9.Thetwocommonmisconceptionsaboutriskmanagementarethenotionthatriskmanagement is concerned primarily with the risks of giant industrial organizations and that there isan anti-insurance bias in the risk management philosophy. See page 23.The first misconception—that risk management is concerned primarily with the risks of giantorganizations probably developed because much of the literature in the field came from practicingrisk managers. These authors naturally wrote about the problems with which they were concerned,such as self-insurance plans, captive insurers, and other techniques that do apply primarily to giant- 18 -

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organizations.In fact, the risk management philosophy and approach applies to organizations ofall sizes and to individuals as well for that matter.The second misconception about risk management--that it is anti-insurance in its orientationand that it seeks to minimize the role of insurance in dealing with risk--also stems from riskmanagement literature. Again, many writers from the academic world have sought to avoid writingabout insurance in their discussions of risk management.In an effort to avoid writing insurancebooks and teaching insurance courses, some academics in the insurance field relegated insurance toa subordinate role in the risk management process, and focused instead other approaches to dealingwith risk, such as risk control, risk retention, risk avoidance, and captive insurance companies.Contrary to the popular notion, the essence of risk management is not on the retention ofexposures.Rather it is on dealing with risks by whatever mechanism is most appropriate, and inmany instances, commercial insurance will be the only acceptable approach.While the riskmanagement philosophy suggests that there are some risks that should be retained, it also dictatesthat there are some risks that must be transferred, and insurance plays a central role in the riskmanagement process.10.The term risk management is increasingly used to describe the management of speculativerisk,particularly by personsinthefield offinance.Financialrisk managementinvolvesmanagement of financial risks as market risk, credit risk, and interest rate risk.Enterprise riskmanagementisbroader,andwouldbring togetherthe managementofallrisks—financial,operational,includingtraditionallyinsuredhazards,andstrategic—intoasingleportfolio.Traditional risk management is responsible primarily for managing pure risks (or operationalrisks). See pages 15-16.Note that ideally, the traditional risk manager should be involved in decisions relating to theoverall operation of the organization for the purpose of evaluating various courses of action fromthe pure risk perspective.For example, the decision to manufacture a new product line or moveinto a new area of operations will inevitably involve new pure risks.The decisions relating tothese strategies should include appropriate consideration of these pure risks, ideally before thedecision is made.Answers to Questions for Discussion1.The areas in which a risk manager should be knowledgeable are reflected in the techniquesfor dealing with risk; risk control and risk financing.It would seem that a well-rounded riskmanagershouldhavesomeknowledgeregardinglosspreventionandcontroltechniques.Similarly, one would expect a risk manager to have a good understanding of risk financing options,with a solid understanding of insurance and how it works. Because risk management is basically aproblem in decision-making, the risk manager also needs to understand decision theory.Because risk management encompasses so many fields, it is obviously difficult for one to bean expert in everything related to risk management. Most risk managers tended to be specialists inone particular phase of risk management (e.g., insurance or loss prevention) or generalists withoutexpertise in any of the specific sub-disciplines of risk management.Although the study of riskmanagement does not attempt to create experts in all risk-management fields, it does address theinterrelationships of the techniques of risk management. More importantly, it creates a conceptual- 19 -

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

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CHAPTER 3THE INSURANCE DEVICEGeneral Comments on the ChapterThis chapter introduces the student to the insurance mechanism and the manner in which itoperates. It defines insurance from the viewpoint of both the individual and from the viewpoint ofsociety, and stresses the notion that the essence of insurance is the transfer of risk and the sharingof the losses that do occur on some equitable basis.The discussion of the law of large numbersand probability theory is very basic, and even those students with little or no statistical backgroundshould have little trouble with it.In discussing the requirement of a large number of insureds, we point out that the largenumber does not relate only to predictability.The law of large numbers is important in achievingpredictability but predictability is important only when the insurance is to be conducted on anadvance premium basis.In post-loss assessment programs the requirement of a large number ofexposures still applies, since there must be a large number of insureds who do not suffer loss whowill pay the losses of the few who do suffer loss.The section entitledInsurance: Transfer or Pooling(page 41) addresses the question whetherthe essence of insurance is transfer or pooling.The discussion points out that transfer is theessential feature of insurance, and that while pooling is an important technique available to thetransferee, it is not an essential feature of the insurance mechanism.The brief discussion of "self-insurance" points out the semantic difficulties inherent in theconcept, and at the same time provides a workable definition for this widely used term. Althoughthe term "self-insurance" poses certain semantic difficulties and conflicts with the usual definitionsof insurance, the term has found widespread acceptance and those who use it know precisely whatthey mean.The term is widely used in state statutes (e.g., most state workers compensation lawspermit "self-insurance,") and in insurance contracts (such as umbrella policies which refer to the"self-insured" retention).The final section of the chapter provides an overview of the forms that insurance can take.The major distinction is, of course, the distinction between social insurance and private orvoluntary insurance.We have added a third class, Public Guarantee Insurance Program toencompass a residual class of insurance plans that do not fit precisely into the private insurance orsocial insurance classes.With respect to the distinction between private insurance and social insurance, the definitionof social insurance proposed by the Committee of Terminology quoted in the text remains the bestcatalogue of the distinguishing characteristics of social insurance.With respect to what we have termed "private" or "voluntary" insurance, neither term in itselfis wholly satisfactory or completely defines the class of insurance contemplated. Private insuranceis usually—but not always voluntary, and voluntary insurance is usually—but again not always—sold by private insurers.In addition to distinguishing between social and private insurance, thechapter also gives a bird's eye overview of the fields of private insurance, subdividing the field into- 21 -

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the three areas of life insurance, accident and health insurance, and property and liabilityinsurance.The third classification, "Public Guarantee Insurance Programs," fills what we consider tohave been a previous void in the classification system.Programs like the FDIC, the SecuritiesInvestor Protection Corporation and the Pension Benefit Guarantee Corporation are clearly anapplication of the insurance principle, yet they do not fit conveniently under the traditionalheadings of social insurance or private insurance. They represent quasi-government plans that usethe insurance mechanism to meet a specific security need.Generally, there is no contract andthose who become entitled to receive benefits gain this entitlement as a matter of law rather thanby contract.Because this chapter introduces the topic of social insurance, there is a temptation to addresssome of the problems facing the social security system here. It seemed more reasonable, however,to defer this discussion until Chapter 11, where the Old-Age, Survivors, Disability and HealthInsurance (OASDHI) program is discussed in greater detail.Important Concepts to be StressedThe most important concepts in the chapter and the principles that we believe should bestressed in the lecture are:•The definition of insurance from the viewpoint of the individual•The definition of insurance from the viewpoint of society•Probability theory and the law of large numbers in insurance•The dual application of the law of large numbers•The desirable elements of an insurable risk•Randomness and adverse selection•The economic contributions of insurance•The concept of "self-insurance"•The distinction between private insurance and social insurance•Public guarantee insurance programsAnswers to Questions for Review1.The elements of an insurable risk are (1) a large number of homogeneous exposure units (2)the loss produced must be definite (3) the loss should be fortuitous (4) the loss should not becatastrophic—i.e., it should be unlikely that all exposure units will suffer loss at the same time.See pages 42-43.2.The dual application of the law of large numbers requires a large enough sample for theinsurer to make a good estimate of the probability, and a sufficient number of exposure unitsinsured to permit the probability to work itself out.Inherent in this concept is the idea that theremust be many exposures that do not suffer loss who make contributions to pay for the losses of thefew who do. See page 40.- 22 -

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3.An increase in the number of observations in a sampling technique has no effect on theunderlying probability of the event.It should, however, increase the accuracy of our estimate ofthe probability. As the number of exposures in the sample is increased, the standard deviation willdecrease, reflecting the increased confidence in our estimate of the probability.4.The two fundamental functions involved in the operation of the insurance mechanism are thetransfer of the risk from the individual to the insurer or the group, and the sharing of losses onsome equitable basis.These functions reduce or eliminate uncertainty for the individual, andprovide a basis for spreading the impact of losses.As noted in the text (page 41), theessentialfeature of insurance is risk transfer.Pooling is an important technique available to the transferee,but it is not a requisite, and insurance transactions can occur in which the risk that is transferred isunique, and in which there is no pooling.Although insurancegenerallyinvolves the reduction ofrisk in the aggregate, which is achieved by pooling, insurance transactions need not involvepooling.5.Inthecaseoftheindividual,insurancesubstitutescertaintyforuncertaintybythesubstitution of the small certain cost (premium) for the large uncertain loss that would exist in theabsence of the insurance.The uncertainty regarding whether or not a loss will occur is notdiminished, but uncertainty regarding financial loss is eliminated for the individual.6.Examples of uninsurable risks might include war (catastrophe), damage caused by termites(not definite in time), and speculative risks (insurance would be self-defeating by reducing oreliminating the potential gain). What is important in this question iswhythe risks are uninsurable.Generally, it will be because the risk does not meet one of the desirable elements of an insurablerisk.7.There are two costs to society that result from the existence of insurance.The first is theamount of loss that is caused by the existence of insurance.To the extent that individualsintentionally cause losses so they may collect under an insurance policy, society suffers losses thatwould not occur in the absence of insurance. The second cost of insurance to society is the cost ofoperating the insurance industry.The resources devoted to the operation of insurance companiesand ancillary insurance-related services consume resources.The chief contributions of insurance are in reducing uncertainty regarding the impact offinancial loss and the function of spreading the losses that do occur. By reducing uncertainty andproviding a mechanism for the sharing of losses, insurance brings peace of mind to the members ofsociety and makes costs more certain.In addition, it provides for more optimal utilization ofcapital. See pages 41- 42.8.The specific conditions of a social insurance plan that distinguish it from private orvoluntary insurance are those specified in the definition of social insurance proposed by theCommission on Terminology of the American Risk and Insurance Association.There are eightconditions listed on page 48 of the text.The most important of these, in our opinion, are the lackof equity and the compulsory nature.9.The three general categories into which private insurance may be divided are life insurance,health insurance, and property and liability insurance.- 23 -

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