Background: Introduction To Risk Management and Insurance: by Del Spencer

CHAPTER 10 Background: Introduction to Risk Management and Insurance
by Del Spencer
Copyright 2004 Pearson Education, Inc. All rights reserved.
10-1
Most Americans have the wrong type of insurance coverage.

Copyright 2004 Pearson Education, Inc. All rights reserved. 10-2
Some types of risks cannot be insured against.

The economic loss from automobile accidents exceeds $100 billion annually.
12 cents out of every dollar consumers spend goes to pay for insurance.
Standard homeowners insurance policies will not pay for flood damage.
Importance of Risk in a Financial Plan

A sound financial plan requires an analysis of major risks that can threaten your financial security. If you fail to plan for these risks, you may not attain your financial goals.
Our balance sheet will show the risks we need to protect against.
Meaning of Risk
Risk is defined as uncertainty of loss.
Pure risk is a situation in which there are only the possibilities of loss or no loss. Examples: premature death of a family head, car accident, sickness or injury, unemployment, destruction of a home and personal property.
Meaning of Risk (continued)

Speculative risk is a situation in which either profit or loss is possible. Examples: buying stock, betting on a horse race, investing in real estate, going into business for yourself. Knowing the difference between pure and speculative risks is important because speculative risks are usually not insurable.
Major Types of Risks

Personal risks
premature death insufficient income during retirement poor health unemployment
Property risks
Liability risks
Personal Risks
Risks of premature death of a household head with unfulfilled financial obligations. These could include dependents to support, children to educate, or a mortgage to be repaid. Four costs that can result from premature death of a household head:
Human life value - present value of the future earnings of the head.
Personal Risks (continued)

Burial cost, uninsured medical bills, probate costs, estate taxes. Replacement income may be inadequate for basic needs.
Non-economic costs - emotional grief of spouse and loss of a role model for the children.
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Risks of insufficient income during retirement.
This is the major risk associated with old age.
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Risk of poor health. Includes both catastrophic medical bills and the loss of earned income.
Cost of major surgery has increased substantially in recent years. Inability to pay catastrophic medical bills is a major cause of personal bankruptcy.
Probability of being disabled before age 65 is higher than is commonly believed.


A person age 25 has a 54% chance of becoming totally disabled for at least 90 days before age 65.
Risk of unemployment.
Regardless of cause, unemployment can cause financial insecurity in 3 ways.
The worker loses his earned income.
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because of economic conditions, may only be able to work part-time and part time pay may not cover basic needs.
Past savings may be exhausted.
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Property Risks
Property owners are exposed to the risk of having their property damaged or destroyed from numerous causes. A direct loss is a financial loss that results from the physical damage, destruction, or theft of the property.
Examples: destruction of personal property in a fire or the theft of your automobile.
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Property Risks (continued)

An indirect loss is a financial loss that results indirectly from the occurrence of a direct physical damage or theft loss.
Examples: fire destroyed home, forced to move to apartment during rebuilding. Moving expenses and rent payments.
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Liability Risks
You are legally liable if you injure someone or damage someones property. Liability risks are extremely important in financial planning.
There is no maximum upper limit on the amount of loss. You can be sued for any amount.
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Liability Risks (cont.)

A lien can be placed on your income and financial assets to satisfy a legal judgment.
Legal defense costs can be enormous.
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Personal Risk Management

Refers to the identification and evaluation of pure risks faced by an individual or family, and to the selection of the most appropriate technique for treating such risks. Steps in Personal Risk Management
Identify potential losses.
Evaluate potential losses. Select the appropriate technique for treating such risk.
Review the program periodically.
Identify Potential Losses

Catastrophic financial losses can result from
Personal risks Property risks Liability risks
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Evaluate Potential Losses

Involves an estimate of the frequency and severity of a potential loss so that the most appropriate technique can be used to deal with the risk.
If loss frequency is small, but severity of loss is catastrophic, these losses should be insured. If loss frequency is high, but loss severity is low, such losses should not be insured.
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Select the Appropriate Technique for Handling Losses
Control.
Avoidance.
Retention. Transfer
Control
Loss control consists of certain activities that reduce both the frequency and severity of loss.
Control has 2 major objectives: loss prevention and loss reduction.
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Reducing Risk
Avoidance
Avoiding certain situations in which losses might occur.
Examples: To not get injured riding a motorcycle, avoid riding a motorcycle. To escape injury from falling off a mountain, avoid mountain climbing.
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Retention
Means that you retain part or all of the loss if it should occur. Can be aggressive or passive. Aggressive or active risk retention means you are aware of the risk and plan to retain part or all of it.
Retention (continued)
Examples of aggressive: Collision insurance with a deductible. The amount of the deductible is that part of the risk that you are retaining.
Passive retention is because of ignorance, indifference, or laziness.

Example: Many worker are not insured against the risk of long-term disability, which from a financial stand point could be more severe than premature death.
Transfer
This means you transfer the risk by purchasing insurance.
Most people rely heavily on insurance as the major method for dealing with risk.
10-29
Non-Insurance Transfers
Methods other than insurance are used to transfer to another party the risks of a loss. Examples:
Purchasing an extending-warranty contract. Collecting a damage deposit from tenants of rental property.
Review the Program Periodically

At least every 2 or 3 years, you should determine if all major risks are adequately covered. Also, review the program when a major event happens in your life; marriage, divorce, new job, new home.
10-31
Chapter 10
Auto and Homeowners Insurance
Chapter Objectives
Explain the role of risk management
Outline typical provisions of auto insurance Describe financial coverage provided by homeowners insurance
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Background on Insurance
Insurance protects you against potential financial losses or liability as a result of unexpected events Its primary function is to maintain your existing level of wealth
Insurance is beneficial even when no payments are received from the insurance company
Managing Risk
Risk: exposure to events or perils that can cause financial loss Risk management: decisions about whether and how to protect against risk
Control or Reduce risk

Avoid risk
Retain risk
Transfer risk
Managing Risk
Accept risk
Feasible when likelihood of financial loss is low
Insure against risk

Premium: the cost of obtaining insurance Benefit is protection from financial loss
Risk management decisions affected by degree of risk tolerance

Role of Insurance Companies

Types of insurance
Many types of insurance available
Most popular forms are property and casualty insurance, life insurance and health insurance
Insurance company operations

Relationship between insurance companies and premiums
10-37

Underwriters: from an insurance perspective, are hired to calculate the risk of specific insurance policies, decide what policies to offer, and what premiums to charge
Insurance company credit ratings and service

Select a company that is in good financial condition Shop around for best coverage and price

Role of insurance agents and brokers
Insurance agent: recommends insurance policies for customers
Captive insurance agent: works for one particular insurance company

Independent insurance agent: represent many different insurance companies
10-39
10-40
Financial Planning Online: Reviews of Insurance Companies

Go to: http://www.gomez.com
Click on: Insurance Carriers: from the Scorecards drop-down list This Web site provides reviews and ratings of various insurance companies and descriptions of services offered by each insurance company.
Auto Insurance
Auto insurance protects you from financial loss from damage or liability resulting from automobile accidents
Insurance policy: contract between an insurance company and the policy holder
Auto insurance policy: specifies the coverage provided by the insurance company for a particular individual and vehicle
10-42
Auto Insurance
Coverage A: Liability Coverage
Bodily injury liability coverage: protects against liability associated with injuries caused by the policy holder Property damage liability coverage: protects against losses that result when the policy holder damages another persons property with their car
Auto Insurance
Auto insurance policy provisions
Policy limits often described as 100/300/50
$100,000 per person injured in an accident
$300,000 for all people combined

$50,000 for property damage
Financial responsibility laws: laws that require individuals who drive cars to purchase a minimum amount of liability insurance
Auto Insurance
Coverage B: Medical Payments Coverage: insures against the cost of medical care for you and other passengers in your car when you are at fault in an accident
Applies only to insured car
10-45
Auto Insurance
10-46
Auto Insurance
Coverage C: Uninsured or Underinsured Motorist Coverage
Uninsured motorist coverage: insures against the cost of bodily injury when an accident is caused by another driver who is not insured
Underinsured motorist coverage: insures against bodily injury an divers who have insufficient coverage
Auto Insurance
Coverage D: Collision and Comprehensive Coverage
Collision insurance: insures against costs of damage to your car resulting from an accident in which the policy holder is at fault Comprehensive coverage: insures you against damage to your car that results from floods, theft, fire, hail, explosions, riots and various other events
Auto Insurance
Deductible: a set dollar amount that you are responsible for paying before any coverage is provided by your insurer
Other provisions are available for an additional premium

Summary of auto insurance provisions
Contained in standard insurance policy
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Financial Planning Online: How Much Car Insurance Do You Need?

Go to: http://insurance.yahoo.com/auto.html
Click on: Coverage Analyzer This Web site provides a recommendation on the amount of car insurance coverage that is appropriate for you.
Auto Insurance
10-51
Factors That Affect Auto Insurance Premiums

Characteristics of your car
Value of car Repair record of your car
Your personal characteristics

Your age
Your mileage
Your driving record

Your location
Discounts Your school performance
Comparing premiums among insurance companies

Always obtain several different quotes Several Web sites offer quotations Compare prices at renewal time
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10-55

Focus on Ethics: Impact of Lawsuits and Fraud on Premiums
Fraudulent claims are unmerited claims Injuries are often exaggerated Insurance companies pass on increased costs to policyholders No-fault insurance programs: do not hold a specific driver liable for causing the accident
Homeowners Insurance
Homeowners insurance: provides insurance in the event of property damage, theft, or personal liability relating to your home
Types of perils covered
Homeowners insurance structured in sic packages, each covering different perils in different amounts
10-58
Personal liability coverage provides protection if someone is injured on your property
Factors that affect homeowners insurance premiums

Value of insured home Deductible Location Degree of protection Discounts
Homeowners Insurance Policy Provisions

Property damage covers damage to the home
Cash value policy: pays you for the value of the damaged property after considering depreciation Replacement cost policy: pays you for the actual cost of replacing the damaged property
Other structures on property also covered
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Personal property is normally covered
Includes furnishings and other personal possessions
Home inventory: contains detailed information about your personal property that can be used when filing a claim
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Personal property replacement cost coverage is available
Personal property floater: an extension of the homeowners insurance policy that allows you to itemize your valuables
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Liability insurance included to cover any lawsuits resulting from an event occurring in your home or on your property
Many other expenses can also be included
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Homeowners Insurance Premiums

Factors that affect homeowners insurance premiums
Value of insured home
Deductible
Location Degree of protection discounts

Reducing your homeowners insurance premium
Increase your deductible
Improve protection
Use one insurer for all types of insurance Stay with the same insurance company Shop around
Financial Planning Online: Purchasing Homeowners Insurance

Go to: http://moneycentral.msn.com/articles/ insure/home/contents.asp This Web site provides step-by-step instructions for purchasing homeowners insurance.
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Filing a Claim
Contact insurance company immediately if damage occurs
Claims adjuster estimates damage Present your home inventory Get an independent estimate
Appeal low estimates by insurance company

Renters Insurance
Renters insurance: an insurance policy that protects your possessions within a house, condominium, or apartment that you are renting Renters insurance policy provisions
Specifies maximum coverage for personal assets Also covers liability from damages to a person on your property
Financial Planning Online: Renters Insurance Quotation

Go to: http://insurance.yahoo.com/r1.html
This Web site provides a customized renters insurance quotation based on information about your personal property.
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Umbrella Personal Liability Policy

Umbrella personal liability policy: a supplement to auto and homeowners insurance that provides additional personal liability coverage
Especially important for wealthy people Must show proof of existing coverage
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How Insurance Fits within Your Financial Plan

Key decisions about car and homeowners, insurance for your financial plan are:
Do you have adequate insurance to protect your wealth?
How much insurance should you plan to have in the future?
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Integrating Key Concepts
10-73
Integrating Key Concepts

Part 1: Financial Planning Tools
Part 2: Liquidity Management Part 3: Financing Part 4: Protecting Your Wealth
In Chapter 10 we learned about auto and homeowners insurance

In Chapter 11 we will learn about health and disability insurance
In Chapter 12 we will learn about life insurance

Part 5: Investing Part 6: Retirement and Estate Planning

Background: Introduction To Risk Management and Insurance: by Del Spencer

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Background: Introduction To Risk Management and Insurance: by Del Spencer

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CHAPTER 10 Background: Introduction to Risk Management and Insurance

Copyright 2004 Pearson Education, Inc. All rights reserved.

Most Americans have the wrong type of insurance coverage.

Some types of risks cannot be insured against.

Importance of Risk in a Financial Plan

Meaning of Risk (continued)

Major Types of Risks

Personal Risks (continued)

Copyright 2004 Pearson Education, Inc. All rights reserved.

Personal Risks (continued)

Copyright 2004 Pearson Education, Inc. All rights reserved.

Personal Risks (continued)

Probability of being disabled before age 65 is higher than is commonly believed.

Personal Risks (continued)

Copyright 2004 Pearson Education, Inc. All rights reserved.

Personal Risks (continued)

Copyright 2004 Pearson Education, Inc. All rights reserved.

Copyright 2004 Pearson Education, Inc. All rights reserved.

Property Risks (continued)

Copyright 2004 Pearson Education, Inc. All rights reserved.

Copyright 2004 Pearson Education, Inc. All rights reserved.

Liability Risks (cont.)

Copyright 2004 Pearson Education, Inc. All rights reserved.

Personal Risk Management

Identify Potential Losses

Copyright 2004 Pearson Education, Inc. All rights reserved.

Evaluate Potential Losses

Select the Appropriate Technique for Handling Losses

Copyright 2004 Pearson Education, Inc. All rights reserved.

Passive retention is because of ignorance, indifference, or laziness.

Copyright 2004 Pearson Education, Inc. All rights reserved.

Review the Program Periodically

Copyright 2004 Pearson Education, Inc. All rights reserved.

Copyright 2004 Pearson Education, Inc. All rights reserved.

Copyright 2004 Pearson Education, Inc. All rights reserved.

Control or Reduce risk

Insure against risk

Risk management decisions affected by degree of risk tolerance

Role of Insurance Companies

Insurance company operations

Copyright 2004 Pearson Education, Inc. All rights reserved.

Role of Insurance Companies

Insurance company credit ratings and service

Role of Insurance Companies

Captive insurance agent: works for one particular insurance company

Copyright 2004 Pearson Education, Inc. All rights reserved.

Role of Insurance Companies

Copyright 2004 Pearson Education, Inc. All rights reserved.

Financial Planning Online: Reviews of Insurance Companies

Copyright 2004 Pearson Education, Inc. All rights reserved.

$300,000 for all people combined

Copyright 2004 Pearson Education, Inc. All rights reserved.

Copyright 2004 Pearson Education, Inc. All rights reserved.

Other provisions are available for an additional premium

Copyright 2004 Pearson Education, Inc. All rights reserved.

Financial Planning Online: How Much Car Insurance Do You Need?

Copyright 2004 Pearson Education, Inc. All rights reserved.

Factors That Affect Auto Insurance Premiums

Your personal characteristics

Factors That Affect Auto Insurance Premiums

Comparing premiums among insurance companies

Factors That Affect Auto Insurance Premiums