T1 MHA, C1 MAMDOUH HAMZA AHMED Professor of Risk Management & Insurance Fellow of the American Risk & Insurance Management Society (FRIMS) Faculty of Commerce

T1MHA, C1

MAMDOUH HAMZA AHMEDProfessor of Risk Management & Insurance

Fellow of the American Risk & Insurance Management Society (FRIMS)

Faculty of Commerce

Cairo University

2006

CH1: RISK IN OUR SOCIETY

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CONTENTS

1-Risk in our Society.

2-Insurance & Risk.

3-Risk Management.

4-Financial Services Companies.

5-Legal Principles in Risk & Insurance.

6-Analysis of Insurance Contract.

7-Life Insurance Contractual Provisions.

8-Life Insurance Policies.


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CONTENTS (Cont’)

9-Annuities.

10-The Mortality Table.

11-Pricing Life & Health Insurance.

12-Life Annuities Premiums.

13-Life Insurance Premiums.

14-Gross Premium.


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Definition of risk: “uncertainty concerning the occurrence of a loss”.

Objective Risk: “the relative variation of actual loss from expected loss”.

-Objective risk declines as the number of exposures increases.

-Objective risk varies inversely with the square root of the number of cases under observation.

-Objective risk can be statistically measured by the coefficient of variation.


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The Law of large numbers states that: "as the number of exposures units increases, the more closely the actual loss experience will approach the expected loss experience".

Subjective Risk: “uncertainly based on a person’s mental condition or state of mind”. -Subjective risk varies depending on the individual.

-Two persons in the same situation can have a different perception of risk, and their behavior may be altered accordingly.


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-High subjective risk often results in conservative and prudent behavior, while low subjective risk may result in less conservative behavior.

Chance of loss: “the probability that an event will occur”.

1-Objective Probability: is “the long-run relative frequency of an event based on the assumptions of an infinite number of observation and of no change in the underlying conditions”.


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First, can be determined by deductive reasoning (ex: probability of getting a head from the toss is ½ because there are 2 sides).

Second, can be determined by inductive reasoning (ex: probability that a person age 21 will die before age 26 by analysis of past mortality experience).

2-Subjective Probability: is “the individual’s personal estimate of the chance of loss”.


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-Subjective probability doesn't coincide with objective probability (ex: buying a lottery ticket on your birthday, you overestimate chance of winning).

-Many factors influence subjective probability: age, gender, intelligence education, etc…).


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Chance of Loss Distinguished from Objecive Risk: Chance of loss is the probability that an event that causes a loss will occur but, objective risk is the relative variation of actual loss from expected loss.

-Chance of loss may be identical for 2 different groups, but objective risk may be different.

Ex: 10,000 homes insured in Cairo & 10,000 homes insured in Alex. & chance of loss in each city is 1%.


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Thus, on average, 100 homes should burn annually in each city. If the annual variation in losses ranges from 75 to 125 in Cairo, & from 90 to 110 in Alex.

Then objective risk is greater in Cairo even though the chance of loss in both cities is the same.

Peril: is “the cause of loss”. If a car is damaged in a collision, collision is the peril (cause) of loss.


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Hazard: “a condition that increases the chance of loss”. There are 3 types of hazards:

1-Physical Hazard: is “a physical condition that increases the chance of loss”.

Ex: icy roads increase chance of auto accident & a defective lock increases chance of theft.

2-Moral Hazard: “dishonesty or character defects in an individual that increases the frequency or severity of loss”.


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Ex: faking an accident to collect from the insurer, inflating the amount of a claim, & intentionally burning an insured property.

-Moral hazard is present in all forms of insurance, & it is difficult to prevent.

-Dishonest insurds rationalize their actions on “the insurer has plenty of money”. This is wrong, insurers transfer this cost to the insurds again (increases the premiums).


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Methods of controlling moral hazard: underwriting, deductibles, waiting periods, exclusions.

3-Morale Hazard: “carelessness or indifference to a loss because of the existence of ins.”.

Ex: leaving car keys in unlocked car increases chance of theft & changing lanes without signaling increases chance of accident.


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Pure & Speculative Risks: 1-Pure risk: “a situation in which there are

only the possibilities of loss or no loss”.Ex: premature death, car accident, …,fire.2-Speculative risk: “a situation in which either

profit or loss is possible”.Ex: purchasing shares, going into business.Why Distinguishing between pure & speculative:First: private insurers insure only pure risks.Second: the law of large #'s applies easily to

pure risks than to speculative risks


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Third: society may benefit from occurring speculative risks but, harmed from pure risks.

Ex: a firm may produce cheap computers. So, some competitors went into bankruptcy. But, society benefits from cheap products.

Fundamental & Particular Risks:1-Fundamental Risk: “a risk that affects the

entire economy or large #'s of persons”. Ex: unemployment, war, earthquakes & floods

result in billions of dollars of property loss & large #'s of deaths.


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2-Particular Risk: “a risk that affects only individuals & not the entire community.

-Ex: car theft, bank robbery & house fire. Distinguishing between Fundamental &

Particular Risk: most fundamental risks need governmental assistance ins. & subsidies to be covered .

Types of Pure Risk: personal, property & liability risks.

1-Personal Risks: “risks that directly affect an individual".

-Ex: loss or reduction of earned income, extra expenses,... etc.


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There are 4 personal risks: 1\1-Premature Death: is “the death of a

household head with unfulfilled financial obligations”.

-Ex: dependents to support, a mortgage to be paid off, or children to educate.

-Thus, the death of a 10 yrs old child is not a “premature death” in the economic sense (no financial obligations).


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2\1-Insufficient Income During Retirement:-Retirement means losing earned income.-Unless having sufficient private financial

assets or social security or private pension, you will be exposed to financial insecurity.

-Also, workers do not have enough saving for a comfortable retirement.

3\1-Poor Health: long-term sick or disability cause: loss of income & benefits, cost of medical bills & to take care of the disabled person.


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4\1-Unemployment: it causes financial insecurity in at least 3 ways:

First: losing salary & employee benefits.Second: working part-time means reduced

income & not covering their needs. Third: long period of unemployment means

savings (if available) may be exhausted.2-Property Risks: property are exposed to be

lost or destroyed by fire, flood, accident,…etc.


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Types of property losses: 1\2-Direct Loss: “a financial loss that results

from the physical damage, destruction, or theft of the property”.

Ex: if a restaurant is damaged by a fire, the physical damage (cost of replacement or repair) is a direct loss.

2\2-Indirect or consequential loss: “a financial loss that results indirectly from the occurrence of a direct loss”.

Ex: loss of profits, loss of rents, loss of use of the building, loss of market, & extra expenses while the restaurant is being repaired.


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3-Liability Risks: You can be held legally liable if you do something that result in bodily injury or property damage to someone else.

-Motorists can be held legally liable for the negligent operation of their vehicles.


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Liability risks are important than others: First, no upper limit of the amount of loss.Second, a lien can be placed on your income

& financial assets to satisfy a legal judgment.

Third, legal defense costs could be enormous.


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Methods of Handling Risk: 2 categories:A-Risk Control: refers to techniques that

reduce the frequency & severity of losses & includes:

1-Avoidance. 2-Loss Prevention.3-Loss Reduction.B-Risk Financing: refers to techniques that

provide for the funding of losses & includes:

1-Retention. 2-Noninsurance Transfer.3-Insurance.


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A-Risk Control: 1-Avoidance: you can avoid the risk of losing

your car in an accident by not having one, divorce by not marrying & death in a plane crash by not flying.

-But, it is neither practical nor desirable choice because you can't avoid all risks & you avoid some risks & creates new.

2-Loss prevention: aims at reducing prob. of loss (frequency).

Ex: traffic lights & increasing fines for high speed reduce # of loss.


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3-Loss reduction: aims at reducing severity of loss after it occurs.

-Ex: installing a sprinkler, fire walls & seats belts reduce amount of loss.

B-Risk Financing:1-Retention: an individual or a business firm

retains all or part of a given risk. -Risk retention can be either active or passive. 2-Non-insurance Transfers: risk is transferred

to a party other than an ins. Co such as. 1/2-Transfer of risk by contracts: risk of a rent

increase can be transferred to the landlord by a long-term lease.


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2/2-Hedging price risks: risk of price change can be transferred to a speculator by purchasing & selling futures contracts

3/2-Incorporation of a business firm: risk of the firm having insufficient assets to pay business debts is shifted to the creditors.

3-Insurance: risk is transferred to an insurance company that spread the loss over huge # of units .


Documents

T1 MHA, C1 MAMDOUH HAMZA AHMED Professor of Risk Management & Insurance Fellow of the American Risk & Insurance Management Society (FRIMS) Faculty of Commerce