Appendix A
Risk Management and Insurance
Is the U.S. facing an insurance crisis? Many believe so. As evidence, they point to dozens of doctors in states throughout the country who are moving or retiring as premiums for medical-malpractice insurance skyrocket. In Nevada, nearly one-third of the state’s obstetricians have stopped accepting new patients in the face of premium increases of as much as 400 percent. One, Dr. Shelby Wilbourn, went even further. He moved his practice 3,000 miles, from Las Vegas to Maine. The move cut Dr. Wilbourn’s annual malpractice insurance bill from $108,000 to less than $10,000.
Some physicians have even staged job actions to protest the high cost of medical-malpractice insurance. Surgeons in several states, including Texas, Nevada, West Virginia, and Pennsylvania, have abruptly resigned or gone on leave to protest the high cost of protecting themselves from lawsuits. Hundreds of patients have been affected by these job actions. According to one survey by the American Hospital Association, 20 percent of the nation’s hospitals have curtailed or even discontinued some services because of rising insurance costs. Comments Dr. Donald Palmisano, president of the American Medical Association, “We consider it a crisis when a woman can’t find a physician to deliver her baby. We consider it a crisis when a trauma center shuts down, and someone who has been seriously injured in an automobile accident has to be transferred to another hospital.”
Doctors, hospitals, and patients aren’t the only ones affected by the insurance crisis. Homeowners in many states are seeing their homeowners’ insurance premiums double or even triple, assuming they can get coverage at all. Homeowners in Texas are especially hard hit. Mary Ann Selva of Dickinson, Texas, saw her annual homeowners’ insurance premium jump from $1,400 to $2,100, for less coverage. Yet, she considered herself fortunate. “I feel incredibly lucky to get reduced coverage at increased rates,” she noted. Real estate agents are now warning buyers to start shopping for insurance as soon as they sign a contract to buy a home. Deb Bryan, a real estate agent in Austin, said that she once had to contact over 100 insurance agents to find coverage for one buyer. State Farm—the nation’s largest home insurer—has stopped writing new policies in Texas and several other states. Farmers Insurance, another large home insurer, even threatened to leave the state entirely.
What are the causes of the insurance crisis? In the case of medical-malpractice insurance, doctors and insurers blame the problem on trial lawyers and rising jury awards in liability lawsuits. Comments David Golden of the National Association of Independent Insurers, “The real sickness is people sue at the drop of a hat, judgments are going up and up and up, and the people getting rich out of this are the plaintiffs’ attorneys.” According to Jury Verdict Research, the median jury award for medical- malpractice cases rose nearly 175 percent over a recent six-year period.
When it comes to explanations for the rising cost of homeowners’ insurance, many insurance companies cite the substantial rise in the number of claims involving mold and related water damage as a major culprit. In Texas alone, the top five home insurers saw their mold-related claims more than quintuple in only one year. In a recent two-year period, these companies paid out more than $1 billion in mold settlements. On top of that, a jury recently awarded a Texas homeowner $32 million in a mold-related lawsuit against Farmers Insurance.
While conceding that such factors as malpractice litigation and mold claims have contributed to rising insurance premiums, industry critics place some of the blame for the current insurance crisis squarely on the shoulders of the insurance industry itself. Insurance companies, they argue, relaxed underwriting standards throughout much of the 1990s in an attempt to keep or gain market share. (Underwriting is the process used by insurance companies to decide what, or whom, to insure and what to charge for insurance coverage.) Insurers sold thousands of policies with overly broad coverage and to higher-risk individuals and organizations. At the same time, however, insurance companies kept premiums artificially low. Consequently, many insurers actually lost money on underwriting—meaning that they paid out more in claims than they collected in premiums—throughout much of the 1990s.
Insurance companies were able to withstand these losses because they were earning very high rates of return on their investments, which more than offset underwriting losses. Unfortunately for insurers, investment returns have plunged in recent years, forcing sharp increases in premiums and decreases in coverage.
Whatever the reasons for the current insurance crisis, many types of insurance are very expensive, and they are getting more expensive each year. Nevertheless, few individuals or organizations can afford to go without insurance protection.1
Overview
Risk is a daily fact of life for both individuals and businesses. Sometimes it appears in the form of a serious illness. In other instances, it takes the form of property loss, such as the extensive damage to homes and businesses due to forest fires in Colorado or tornadoes in Alabama, Ohio, and Tennessee. Risk can also occur as the result of other people’s actions—such as a pizza delivery driver’s running a red light and striking another vehicle. In still other cases, risk may occur as a result of our own actions—we talk on a cell phone while driving or decline an extended service warranty on a new computer.
Businesspeople must understand the types of risk they face and develop methods for dealing with them. One approach to risk is to shift it to specialized firms called insurance companies. This appendix discusses the concept of insurance in a business setting. It begins with a definition of risk.
Concept of Risk
Risk is uncertainty about loss or injury. Consider the risks faced by a typical business. A factory or warehouse faces the risk of fire, burglary, water damage, and physical deterioration. Accidents, judgments due to lawsuits, and customers failing to pay bills are other business risks. Risks can be divided into two major categories: speculative risk and pure risk.
risk uncertainty about loss or injury.
Speculative risk gives the firm or individual the chance of either a profit or a loss. Purchasing shares of stock on the basis of the latest hot tip from an acquaintance at the local health club can result in profits or losses. Expanding operations into a new market may result in higher profits or the loss of invested funds.
Pure risk, on the other hand, involves only the chance of loss. Motorists, for example, always face the risk of accidents. Should they occur, both financial and physical losses may result. If they do not occur, however, drivers do not profit. Insurance often helps individuals and businesses protect against financial loss resulting from pure risk.
Risk Management
Since risk is an unavoidable part of business, managers must find ways of dealing with it. The first step in any risk management plan is to recognize what’s at risk and why it’s at risk. After that, the manager must decide how to handle the risk. In general, businesses have four alternatives in handling risk: avoid it, minimize it, assume it themselves, or transfer it to others.
Executives must consider many factors when evaluating the risks, both at home and abroad. These factors include a nation’s economic stability; social and cultural factors, such as language; available technologies; distribution systems; and government regulations. International businesses are typically exposed to less risk in countries with stable economic, social and cultural, and political and legal environments.
Avoiding Risk
Some of the risks individuals face can be avoided by taking a conservative approach to life. Abstaining from smoking, exercising regularly and staying physically fit, and not driving during blizzards and other hazardous conditions are three ways of avoiding personal risk. By the same token, businesses can also avoid some of the risks they face. For example, a manufacturer can locate a new production facility away from a flood-prone area.
When deciding which risks to avoid, firms should also assess the benefits of taking a risk. For instance, introducing new products involves a substantial amount of risk, but it also offers high rewards. Although avoiding all risks may ensure a firm’s profitability, it stifles innovation. As a result, most industry-leading companies are willing to take prudent amounts of risk.
They Said It
If the lion didn’t bite the tamer every once in a while, it wouldn’t be exciting.
—Darrell Waltrip (b. 1947) American race car driver
Reducing Risk
Managers can reduce or even eliminate many types of risk by removing hazards or taking preventive measures. Many companies develop safety programs to educate employees about potential hazards and the proper methods of performing certain dangerous tasks. For instance, any employee who works at a hazardous waste site is required to have training and medical monitoring that meet the federal Occupational Safety and Health Administration (OSHA) standards. The training and monitoring not only reduce risk but pay off on the bottom line. Aside from the human tragedy, accidents cost companies time and money.
Although many actions can reduce the risk involved in business operations, they cannot eliminate risk entirely. Most major business insurers assist their clients in avoiding or minimizing risk by offering the services of loss-prevention experts to conduct thorough reviews of their operations. These health and safety professionals evaluate customers’ work environments and recommend procedures and equipment to help firms minimize worker injuries and property losses.
Self-Insuring against Risk
Instead of purchasing insurance against certain types of pure risk, some companies accumulate funds to cover potential losses. So-called self-insurance funds are special funds created by periodically setting aside cash reserves that the firm can draw on in the event of a financial loss resulting from a pure risk. A firm makes regular payments to the fund, and it charges losses to the fund. Such a fund typically accompanies a risk-reduction program aimed at minimizing losses. Self-insurance is most useful in cases in which a company faces similar risks and the risks are spread over a broad geographical area.
self-insurance fund special fund created by setting aside cash reserves periodically that can be drawn upon in the event of a loss.
One of the most common forms of self-insurance is in the area of employee health insurance. Most companies provide health insurance coverage to employees as a component of their benefits program. Some firms, especially large ones, find it more economical to create a self-insurance fund covering employee health-care expenses, as opposed to purchasing a health insurance policy from an insurance provider.
Shifting Risk to an Insurance Company
Although a business or not-for-profit organization can take steps to avoid or reduce risk, the most common method of dealing with it is to shift it to others in the form of insurance—a contract by which an insurer, for a fee, agrees to reimburse another firm or individual a sum of money should a loss occur. The insured party’s fee to the insurance company for coverage against losses is called a premium. Insurance substitutes a small, known loss—the insurance premium—for a larger, unknown loss that may or may not occur. In the case of life insurance, the loss—death—is a certainty; the main uncertainty is the date it will occur.
insurance contract by which the insurer, for a fee (the premium), agrees to reimburse another firm or individual a sum of money should a loss occur.
It is important for the insurer to understand the customer’s business, risk exposure, and insurance needs. Firms that operate in several countries usually choose to do business with insurance companies that maintain global networks of offices.
Basic Insurance Concepts
Figure A.1 illustrates how an insurance company operates. The insurer collects premiums from policyholders in exchange for insurance coverage. The insurance company takes some of these funds and uses them to pay current claims and operating expenses. What’s left over is held in the form of reserves, which are in turn invested. Reserves can be used to pay for unexpected losses. The returns from insurance company reserves may allow the insurer to reduce premiums, generate profits, or both. By investing reserves, the insurance industry represents a major source of long-term financing for other businesses.
FIGURE A.1
How an Insurance Company Operates
An insurance company is a professional risk taker. For a fee, it accepts risks of loss or damage to businesses and individuals. Three basic principles underlie insurance: the concept of insurable interest, the concept of insurable risks, and the law of large numbers.
Insurable Interest
To purchase insurance, an applicant must demonstrate an insurable interest in the property or life of the insured. In other words, the policyholder must stand to suffer a loss, financial or otherwise, due to fire, storm damage, accident, theft, illness, death, or lawsuit. A homeowner, for example, has an insurable interest in his or her home and its contents. In the case of life insurance coverage purchased for someone providing the bulk of a household’s income, the policyholder’s spouse and minor children have a clear insurable interest.
insurable interest demonstration that a direct financial loss will result if some event occurs.
A firm can purchase property and liability insurance on physical assets—such as offices and factories—to cover losses due to such hazards as fire and theft because the company can demonstrate an obvious insurable interest. Similarly, because top managers are important assets to a company, the firm can purchase key executive insurance on their lives. By contrast, a businessperson cannot collect on insurance to cover damage to property of competitors because that person cannot demonstrate an insurable interest.
Insurable Risk
Insurable risk refers to the requirements that a risk must meet for the insurer to provide protection. Only some pure risks, and no speculative ones, are insurable. Insurance companies impose five basic requirements for a pure risk to be considered an insurable risk:
1. The likelihood of loss should be reasonably predictable. If an insurance company cannot reasonably predict losses, it has no way of setting affordable premiums.
2. The loss should be financially measurable.
3. The loss should be accidental, or fortuitous.
4. The risk should be spread over a wide geographical area.
5. The insurance company has the right to set standards for accepting risk. The process of setting these standards is known as underwriting.
insurable risk requirement that a pure risk must meet for the insurer to agree to provide protection.
Law of Large Numbers
Insurance is based on the law of averages, or statistical probability. Insurance companies have studied the chances of occurrences of deaths, injuries, property damage, lawsuits, and other types of hazards. Table A.1 is an example of the kind of data insurance companies examine. It shows the number of automobile accidents, by age of the driver, for a recent year. From their investigations, insurance companies have developed actuarial tables, which predict the number of fires, automobile accidents, or deaths that will occur in a given year. Premiums charged for insurance coverage are based on these tables. Actuarial tables are based on the law of large numbers. In essence, the law of large numbers states that seemingly random events will follow a predictable pattern if enough events are observed.
actuarial table probability calculation of the number of specific events—such as deaths, injuries, fire, or windstorm losses—expected to occur within a given year.
law of large numbers concept that seemingly random events will follow a predictable pattern if enough events are observed.
Table A.1 Relationship between the Age of Driver and the Number of Motor Vehicle Accidents
Age Group Number of Licensed Drivers Accidents per 100 Licensed Drivers
19 and under 9,984,000 29
20 to 24 15,529,000 18
25 to 34 37,265,000 13
35 to 44 41,857,000 11
45 to 54 33,662,000 9
55 to 64 21,337,000 7
65 to 74 15,244,000 7
75 and older 10,570,000 7
Source: Statistical Abstract of the United States, Census Bureau Web site, http://www.census.gov, accessed January 9, 2003.
An example can demonstrate how insurers use the law of large numbers to calculate premiums. Previously collected statistical data on a city with 50,000 homes indicates that the city will experience an average of 500 fires a year, with damages averaging $30,000 per occurrence. What is the minimum annual premium an insurance company would charge to insure a house against fire?
To simplify the calculations, assume that the premiums would not produce profits or cover any of the insurance company’s operating expenses—they would just produce enough income to pay policyholders for their losses. In total, fires in the city would generate claims of $15 million (500 homes damaged x $30,000). If these losses were spread over all 50,000 homes, each homeowner would be charged an annual premium of $300 ($15 million divided by 50,000 homes). In reality, though, the insurance company would set the premium at a higher figure to cover operating expenses, build reserves, and earn a reasonable profit.
Some losses are easier for insurance companies to predict than others. Life insurance companies, for example, can pretty accurately predict the number of policyholders who will die within a specified period of time. Losses from such hazards as automobile accidents and weather events are much more difficult to predict. The terrorist attacks of 9/11, for example, resulted in roughly $40 billion in insured losses.
Sources of Insurance Coverage
The insurance industry includes both private companies, such as Prudential, State Farm, and GEICO (part of famed investor Warren Buffet’s Berkshire Hathaway), and a number of public agencies that provide insurance coverage for business firms, not-for-profit organizations, and individuals. Let’s look at the primary features of this array of insurers.
Public Insurance Agencies
A public insurance agency is a state or federal government unit established to provide specialized insurance protection for individuals and organizations. It provides protection in such areas as job loss (unemployment insurance) and work-related injuries (workers’ compensation). Public insurance agencies also sponsor specialized programs, such as deposit, flood, and crop insurance.
Unemployment Insurance Every state has an unemployment insurance program that assists unemployed workers by providing financial benefits, job counseling, and placement services. Compensation amounts vary depending on workers’ previous incomes and the states in which they file claims. These insurance programs are funded by payroll taxes paid by employers.
Workers’ Compensation Under state laws, employers must provide workers’ compensation insurance to guarantee payment of wages and salaries, medical care costs, and such rehabilitation services as retraining, job placement, and vocational rehabilitation to employees who are injured on the job. In addition, workers’ compensation provides benefits in the form of weekly payments or single lump-sum payments to survivors of workers who die as a result of work-related injuries. Premiums are based on the company’s payroll, the on-the-job hazards to which it exposes workers, and its safety record.
Social Security The federal government is the nation’s largest insurer. The Social Security program, established in 1935, provides retirement, survivor, and disability benefits to millions of Americans. Medicare was added to the Social Security program in 1965 to provide health insurance for persons 65 years or older and certain other Social Security recipients. More than nine of ten workers in the U.S. and their dependents are eligible for Social Security program benefits. The program is funded through a payroll tax, half of which is paid by employers while the other half is paid by workers. Self-employed people pay the full tax.
New York Life is a mutual insurance company, which is owned by its policyholders. As the company points out in its ad, “Our policyholders are really buying a promise—that we’ll be here to pay a claim, fund your retirement, or pay for nursing home costs.”
Private Insurance Companies
Much of the insurance in force is provided by private firms. These organizations provide protection in exchange for the payment of premiums. Some private insurance companies are stockholder owned, and therefore are run like any other business, and others are so-called mutual associations. Most, though not all, mutual insurance companies specialize in life insurance. Technically, mutual insurance companies are owned by their policyholders, who may receive premium rebates in the form of dividends. In spite of this, however, there is no evidence that an insurance policy from a mutual company costs any less than a comparable policy from a stockholder-owned insurer. In recent years, a number of mutual insurance companies have reorganized as stockholder-owned companies, including Prudential, one of the nation’s largest insurers.
Types of Insurance
Individuals and businesses spend hundreds of billions of dollars each year on insurance coverage. All too often, however, both business firms and individual households make poor decisions when buying insurance. Several commonsense tips for buying insurance are offered in Table A.2. Although insurers offer hundreds of different policies, they all fall into three broad categories: property and liability insurance, health and disability insurance, and life insurance.
Table A.2
Some Commonsense Tips When Buying Insurance
• Insure against big losses, not little ones. Buy insurance to protect against big potential losses, but don’t buy insurance to protect against small losses. A good example of this tip in action is to select the highest deductible you can afford on your property and liability insurance policies.
• Buy insurance with broad coverage, not narrow coverage. For example, it is much more cost-effective to buy a comprehensive health insurance policy, one that covers a wide range of illnesses and accidents, rather than several policies that cover only specific illnesses and accidents. It is extremely expensive to buy insurance coverage one disease at a time.
• Shop around. Insurance premiums for the same coverage can vary substantially....
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