Seminar for Oklahoma State Legislators March 20, 2013

INFORM+INSPIRE

The Griffith Insurance Education Foundation

Basic Principles of Insurance & Risk Management

University of Central Oklahoma

Finance – Insurance and Risk Management

Stuart MacDonald, Gerald Wilkins, Allen Arnold

Seminar for

Oklahoma State LegislatorsMarch 20, 2013

Seminar Agenda Overview of Insurance Principles Types of Insurance Regulation and Legislation

Overview of Insurance Principles

Definition of Risk The Role of Insurance Risk Pooling Adverse Selection Concept of Moral Hazard

Definition of Risk Risk refers to uncertainty An unknown or unexpected event Risk can be strategic, unintentional,

systemic, fortuitous

The Role of Insurance According to the American Risk and

Insurance Association, “insurance is the pooling of fortuitous losses by transfer of such risks to insurers, who agree to indemnify insureds for such losses, to provide other pecuniary benefits on their occurrence, or to render services connected with the risk” (Redja, p. 20, 2011).

Characteristics of Insurance

Pooling of Losses Payment of Fortuitous Losses Risk Transfer Indemnification

Risk Pooling Spreads the loss suffered by an

individual over the whole group Based on the Law of Large Numbers

Payment of Fortuitous Losses

Unforeseen Unexpected Result of Chance

Transfer of Risk Pure risk transferred from an insured

to an insurer for a fee (insurance premium)

Indemnification Restoring an insured to their

approximate pre-loss financial position

Concept of Peril and Hazard A peril is the cause of a loss

A hazard is a factor that creates or contributes to a loss

Physical Hazard Physical condition that increases the

frequency and/or severity of a loss

Moral Hazard Dishonest or deceitful statements or

behavior in order to defraud the insurer, thereby increasing the frequency and/or severity of loss claims

Insurance fraud causes increases in premium rates for everyone

Attitudinal Hazard Carelessness or indifference to a loss,

thereby increasing the frequency and/or severity of loss claims

Legal Hazard Characteristics of the legal system or

regulatory environment that increases the frequency and/or severity of loss claims

Adverse Selection Tendency for insurance applicant with

a higher than average loss potential (sub-standard risk) to acquire insurance protection at less expensive (standard risk) premium rates

Characteristics of an Ideally Insurable Risk Large number of exposure units Accidental and unintentional loss Determinable and measurable Not a catastrophic loss Chance of loss must be calculable Economically feasible premium

Risk Management Matrix Low frequency and severity: Retention High frequency and low severity: Loss

Prevention and Retention Low frequency and high severity:

Transfer Risk (Insurance) High frequency and high severity:

Avoidance

INFLATION-ADJUSTED U.S. CATASTROPHE LOSSES BY CAUSE OF LOSS, 1992-2011

(1) Estimated property losses adjusted for inflation through 2011 by ISO using the GDP implicit price deflator. Excludes catastrophes causing direct losses less than $25 million in 1997 dollars. Does not include flood damage covered by the federally administered National Flood Insurance Program.(2) Excludes snow.(3) Includes wildland fires.(4) Includes losses from civil disorders, water damage, utility service disruptions, and any workers compensation catastrophes generating losses in excess of PCS's threshold after adjusting for inflation.Source: The Property Claim Services (PCS) unit of ISO, a Verisk Analytics company.

Why Insurers Become Insolvent

Note that Fraud outranks Catastrophe Losses.

Types of Insurance Personal Lines

Life Health Homeowners Auto

Reinsurance and Surplus Lines

Source: SNL Financial, Inc.

2011 U.S. Net Pre-miums Written

P&CLifeA&H

Personal Lines - Life Life insurance is justified if others are

financially dependent on the insured Term Insurance vs. Whole Life Insurance Ownership Clause Incontestable Period / Suicide Clause Death benefit proceeds are tax-exempt Life Income Options / Annuities

Personal Lines - Health Patient Protection and Affordable Care

Act State Health Insurance Exchanges No pre-existing conditions No lifetime or annual limits Coverage for children to age 26

2011 Life/A&H U.S. NPW by Line

Personal Lines - Homeowners Homeowners 3 (Special Form)

All-Risks Coverage, except named exclusions (Earthquake, Flood, War, Nuclear Radiation)

Homeowners 6 (Condominiums) Same as above

Homeowners 4 (Renters Insurance) Named Perils (NOT All-Risks)

Personal Lines - Auto Personal Auto Policy

Liability Coverage Medical Payments Coverage Uninsured / Underinsured Motorists Collision and Comprehensive Exclusions (intentional injury or damage,

racing, road rage, business use, etc.)

2011 P&C U.S. NPW by Line

State Trends in Auto and Homeowners Pricing 2011 report by the Insurance

Research Council indicates a rapid increase in the severity of claims, and a slow but steady increase in the frequency of non-severe claims.

Commercial Auto most stable underwriting

Reinsurance Primary insurer that writes the

insurance transfers to another insurer (the reinsurer) part or all of the potential losses associated with such insurance

Reasons for Reinsurance Increase underwriting capacity Stabilize profits Reduce the unearned premium reserve Protection against catastrophic losses

(e.g. reinsurers paid a large part of the $41 billion insured losses arising from Hurricane Katrina which significantly reduced losses paid by primary insurers)

Surplus Lines Surplus lines refers to any type of

insurance for which there is no insurer licensed by the State of Oklahoma that will write the type and amount of insurance requested by the insured

Coverage must be placed by a surplus lines broker with a nonadmitted insurer which is not licensed to do business in Oklahoma (e.g. Lloyd’s of London)

Surplus Lines Surplus lines carriers are registered

with the Oklahoma Insurance Department

A 6% surplus lines tax is levied on insurance premiums for surplus lines coverage; tax is paid by the surplus lines broker placing the coverage for the insured

Regulation of Insurance National Association of Insurance

Commissioners (NAIC) All 50 states, Wash. D.C, 5 US Territories Maintain insurer solvency Regulate fair and reasonable rates Ensure availability of insurance Consumer protection and education

State Regulation of Insurance Oklahoma Insurance Department

Enforce insurance-related laws Protect consumers Promote competitive insurance markets License and educate insurance agents

and adjusters, funeral home directors, bail bondsmen, real estate appraisers

State Guaranty Funds Provide protection from losses if an

insurer becomes insolvent Life and Health Insurance Guaranty

Association Property and Casualty Insurance

Guaranty Association

Oklahoma Guaranty Associations When a licensed insurer fails, other

licensed insurance carriers are assessed according to the % of premiums they write in the State to pay the claims of the failed carrier

Oklahoma Guaranty Associations Each insurer who pays an assessment

is permitted to take the amount they pay as a credit against their premium taxes (licensed insurance carriers pay a 2.25% premium tax on all premiums they bill their insureds)

Solvency, Pricing, Rate Adequacy Insolvency result of catastrophic losses,

inadequate reserves and rates, mismanagement, bad investments, etc

Premium pricing function of expected losses, expense loading, investments

Rates regulated to balance insurer profitability and prevent consumer gouging

Regulatory Methods to Ensure/Monitor Insurer Solvency

State insurance departments utilize strict methods and requirements to maintain insurer solvency

Licensing and financial requirements Risk-based capital standards Submission of financial statements In-field examinations of insurer practices

Policy Forms Insure Consistency of Product Consistency of Interpretation of

Language Set Coverage Standards

Balance between Consumers and Insurers Government Failure vs. Market Failure Bad Faith vs. Fraud State Guaranty Funds vs. Moral

Hazard Sound Underwriting vs. Red Lining

Rate Filing Interstate Insurance Compact Must Insure Solvency McCarran-Ferguson Act Prevent “Destructive” Competition

Issues in Insurance Legislation

Tag initiative uninsured drivers loss of state revenue

Workers Compensation

Captive Insurance

Questions?

Comments?

Melissa Kuhn Wheeler, The Griffith Insurance Education Foundation, (855) 288-7743, mwheeler@griffithfoundation.org

Dr. Stuart MacDonald, (405) 974-2152, smacdonald@uco.eduGerald Wilkins, (405) 974-5566, gwilkins@uco.eduAllen Arnold, (405) 974-2171, aarnold1@uco.edu

INFORM+INSPIRE

Thank you for allowing us to present this seminar on Insurance and Risk Management. Please contact us if we can be of further assistance.

This presentation can be downloaded at: www.griffithfoundation.org/public-policy/resources/

Seminar for Oklahoma State Legislators March 20, 2013

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