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Lecture Risk management and insurance - Lecture No 16: Government regulation of insurance

This chapter’s objectives are to: Present value analysis, net present value analysis of installation of sprinkler systems, select the optimal mix of risk retention and risk transfer, the deductible decision, the self-insurance decision,. | Government Regulation of Insurance Lecture No. 16 1 2 Present Value Analysis If $1 is invested in an interest rate of i The interest earned during the first year is i × 1 = i The total in the fund at the end of the year is 1 + i Which represents the original $1 plus the $i in interest earnings If no payments are made from the fund during the second year The total amount in the fund after two years will be Principal + interest = (1 + i) × i(1 + i) = (1 + i)2 The relationship is such that an original sum of $P invested at an annual interest rate of i for N years will accumulate to a value of $Q as follows P(1 + i)N = Q 3 Present Value Analysis A slightly different way of thinking about the role of interest in these types of situations is to ask the question How much money must be invested now at interest rate i so that it accumulates to a value of $Q after N years? By rearranging the terms in the previous general formula, P is Q ÷ [(1 + i)N] = P This is referred to as the present value | Government Regulation of Insurance Lecture No. 16 1 2 Present Value Analysis If $1 is invested in an interest rate of i The interest earned during the first year is i × 1 = i The total in the fund at the end of the year is 1 + i Which represents the original $1 plus the $i in interest earnings If no payments are made from the fund during the second year The total amount in the fund after two years will be Principal + interest = (1 + i) × i(1 + i) = (1 + i)2 The relationship is such that an original sum of $P invested at an annual interest rate of i for N years will accumulate to a value of $Q as follows P(1 + i)N = Q 3 Present Value Analysis A slightly different way of thinking about the role of interest in these types of situations is to ask the question How much money must be invested now at interest rate i so that it accumulates to a value of $Q after N years? By rearranging the terms in the previous general formula, P is Q ÷ [(1 + i)N] = P This is referred to as the present value of $Q for N years at interest rate i 4 Net Present Value Analysis of Installation of Sprinkler Systems 5 Select the Optimal Mix of Risk Retention and Risk Transfer As previously stated, loss control decisions should be made as part of an overall risk management plan That also considers the techniques of risk retention and risk transfer Often both of these techniques will be used The relevant question becomes What is the appropriate mix between these two techniques? 6 General Guidelines As a rule, risk retention is optimal for losses that have a low expected severity With the rule becoming especially appropriate when expected frequency is high Another general guideline applies to risks that have a low expected frequency but a high potential severity In this situation, risk transfer is often the optimal choice When losses have both high expected severity and high expected frequency It is likely that risk transfer, risk retention, and loss control all will need to be used in varying .