Risk Management and Insurance
Risk Management and Insurance
Risk Management and Insurance
and Insurance
Etti Baranoff
Virginia Commonwealth University
www.wiley.com/college/baranoff
To Steve, Dalit, Liat, Aviva, Josh, Jeremy, and
Timy, for their patience and support.
This book was set in Minion and was printed and bound by R. R. Donnelly & Sons. The cover was
printed by Lehigh Press.
This book was published by John Wiley & Sons, Inc. under exclusive license from Leyh Publishing,
LLC.
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ISBN 0-471-27087-3
10 9 8 7 6 5 4 3 2 1
BRIEF CONTENTS
PA RT I
FUNDAMENTALS OF RISK MANAGEMENT AND INSURANCE 9
Risk 10
Insurance 28
PA RT I I
INSURANCE OPERATIONS, INSTITUTIONS, AND MARKETS 69
PA RT I I I
INSURANCE CONTRACTS 121
PA RT I V
PROPERTY AND LIABILITY RISKS 161
PA RT V
LIFE, HEALTH, AND RETIREMENT RISKS 329
Case 1 503
Case 2 509
Case 3 525
Case 4 541
CONTENTS
Preface xx
About the Author xxv
PA RT I
FUNDAMENTALS OF RISK MANAGEMENT AND INSURANCE 9
Risk 10
Connection 10
Nature of Risk 11
The Feelings Associated with Risk 11
Definition of Risk 12
Measurement of Risk 13
Specific Measurement Techniques 13
Law of Large Numbers 16
Elements of Pure Risk 16
Exposures and Risks 17
Perils 18
Hazards 18
Emerging and Growing Risks 21
Key Terms 23
Discussion Questions 23
Exercises 25
Notes 25
Appendix 1.1 26
Appendix 1.2 27
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Insurance 28
Connection 28
Nature of Insurance 29
Definition of Insurance 29
How Insurance Works 30
Risk Transfer (Assumption) 30
Loss Sharing (Risk Distribution) 31
Discrimination: The Essence of Pooling 32
Ideal Requisites for Insurability 34
Many Similar Exposure Units 34
Accidental Losses 35
Small Possibility of Catastrophe 36
Definite Losses 37
Determinable Probability Distribution 37
Economic Feasibility 38
Summary of Insurable Risks 39
Types of Insurance 40
Personal, Group, or Commercial 40
Life/Health or Property/Casualty 40
Private or Government 41
Voluntary or Involuntary 41
Selecting an Insurer 41
Financial Strength 41
Key Terms 42
Discussion Questions 42
Exercises 43
Notes 43
PA RT I I
INSURANCE OPERATIONS, INSTITUTIONS, AND MARKETS 69
PA RT I I I
INSURANCE CONTRACTS 121
PA RT I V
PROPERTY AND LIABILITY RISKS 161
PA RT V
LIFE, HEALTH, AND RETIREMENT RISKS 329
Case 1 503
Case 2 509
Case 3 525
Case 4 541
Appendix A 549
Appendix B 575
Appendix C 589
Appendix D 597
Appendix E 599
CONTENTS xix
Appendix F 613
Index 627
PREFACE
TEXT ORGANIZATION
■ An emphasis on the big picture—the Connection section. The insurance
industry, operations, and markets have been brought to the front of the book to
clarify the “big picture” for students. Risk and insurance can appear to be a
complex puzzle composed of many pieces. In addition to the early overview of
industry, operations and markets, a “Connection” section begins each chapter to
highlight the relationships between various concepts and components of risk
and insurance, so that students know how the pieces fit together.
■ Chapter 3 presents current risk management practices, including enter-
prise risk management. The chapter moves from traditional risk manage-
ment through risk mapping to enterprise risk management, including the use
of the capital markets and cat bonds. Chapter 3 can be used to introduce risk
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PREFACE xxi
management or for advanced study. Out of the cases at the end of the text,
two are particularly relevant to this chapter: Case 3 provides advanced risk
management tools for a large corporation, and Case 4 experiments with the
financial risk management tools described in Chapter 3.
■ Chapter 4 contains a review of insurance company operations and loss devel-
opment techniques. The chapter includes an actuarial loss development trian-
gle technique for loss reserves and rate calculations. Understanding this process
of estimating future losses based on past losses is at the heart of insurance oper-
ations. Students who understand how insurance companies deal with losses will
understand the underlying dynamic of the industry. Thus, the up-front study of
the loss development technique in this chapter is part of a conceptual frame-
work that will help students learn the details of insurance that are covered later
in the text.
■ Chapter 5 contains a review of insurance markets, underwriting cycles, regu-
lated and unregulated markets, and regulation. The chapter is designed to
furnish an understanding of the global operations of insurance markets, so
student can appreciate the importance of market conditions (and the under-
writing cycles) on risk management decisions. The types of insurance institu-
tions and the U.S. insurance regulation today are discussed, including the most
recent updates. The chapter incorporates the insurance implications of the
Gramm-Leach-Bliley (GLBA) Financial Services Modernization Act of
November 12, 1999.
■ E-Commerce Risk: This emerging and evolving risk is covered in detail in
Chapters 8, which is devoted to property risk in general, and in Chapter 9,
which is centered around liability risks.
■ Employee benefits and individual life/health products: all new laws are incor-
porated, including EGTRRA 2001, along with case examples of a dental office
for pensions, comparative matrices for group health insurance and group
underwriting, and rate quotes and policy features for individual health policies
(in Chapter 19.) This area is supplemented with Case 2, an employee benefits
portfolio for a hypothetical company.
■ Social Security: The chapter is updated with the most recent year’s data (2003).
All data will be kept current on the text’s Web site.
■ Case studies: The book begins with an introductory case on the losses of
September 11, 2001, and concludes with a section featuring comprehensive
cases in risk management and insurance for personal needs and business needs.
These cases help students recognize the relevancy and applications of the book’s
concepts in the real world.
■ Introduction with cases: The introduction provides an overview of all the
elements of the textbook, using the huge losses of September 11 as a first
glimpse into the field. Two victim families are featured, and the insurance
coverages discussed include the United States’ social insurance programs,
employer provided employee benefits, and private insurance. Also, one
business that sustained losses during September 11 is featured, and this
raises discussion of business interruption coverage.
■ Conclusion with case studies: To complete the “big picture” of holistic
risk for a family with hand-on application, Case 1 features the hypotheti-
cal Smith family and their risk management portfolio. To complete the
xxii RISK MANAGEMENT AND INSURANCE
NEW FEATURES
■ Important Issues: Each chapter is filled with current real-life examples to liven
up the study for the student and to clearly show the application of concepts of
risks in our everyday lives. Important Issues boxes include discussions on topics
such as punitive damages, mortality improvements, recent laws affecting health
care, auto rates, business interruption issues, mold, and more.
■ Explore the Internet: At the conclusion of each “Important Issues” box, the
reader is directed to use Web sites applicable to the chapter and the stories.
Within each chapter there are many references to Internet sites the student can
use for additional information and updates.
■ Ethical Dilemma: Each chapter features an “Ethical Dilemma” that deals with
current issues such as the Federal terrorism insurance bill, redlining, obesity
and lawsuits, the conversion of traditional defined benefit plans to cash balance
pension plans, and the tradeoff between health care cost and benefits. At the
conclusion of each story, questions are provided to prompt related discussion.
■ The newest sample personal and commercial property/casualty ISO policies
are discussed in detail along with the most up-to-date ISO sample endorse-
ments for terrorism, e-commerce and mold coverages. Hands-on-examples
using the policies encourage students to truly understand the workings of
these policies.
■ New sample life insurance policies from State Farm are furnished, along with
a thorough explanation, to give a clear understanding of the coverages and life
products available in the market place today.
■ Student-friendly: A clear, readable writing style helps to keep a complicated sub-
ject from becoming overwhelming. In-chapters examples and the “Ethical
Dilemmas” and “Important Issues” let students apply the concepts they’re learning.
■ New Discussion Questions and Exercises at the end of each chapter: Many
new questions and case exercises were added to provide more challenging appli-
cations to the students and encourage the use of the policies provided at the
back of the text.
SUPPLEMENTS
Instructors’ Resources
All teaching supplements will be available for instructors to download from the password-
protected Instructors' Companion Web Site, at www.wiley.com/college/baranoff.
Instructor’s Manual
This guide for instructors begins with suggestions on how to use the textbook to teach
different levels of students, from beginning to intermediate. Specific tips are given in
each chapter for the various levels. Each chapter has an orientation, complete outline,
PREFACE xxiii
and answers to all discussion questions and exercises. In providing answers, we have
included matrices for the comparison questions and spreadsheets for the more quanti-
tative exercises.
Test Bank
The test bank consists of 30 multiple choice questions and 5 or more short answer ques-
tions for each chapter. Key concepts are emphasized throughout, with questions offered at
a range of difficulty levels.
PowerPoint Presentations
PowerPoint slides provided for each chapter present key exhibits and and outlines of the
critical topics in each chapter.
Student Resources
The students’ Web site, www.wiley.com/college/baranoff, will furnish current reading and
exercises, including updates to the Important Issues and Ethical Dilemma boxes.
ACKNOWLEDGEMENTS
This book lists one author, but it is based on the 1996 edition of the text book Risk
Management and Insurance (seventh edition) by S. Travis Prichett, Joan T. Schmit, Helen I.
Doerpinghaus and the late James L. Athearn. Their textbook is the foundation of this text.
Without this foundation and their recommendation that I undertake the overhauling of
their book, I would not have accepted this large project.
My publisher, Leyh Publishing, provided extensive and excellent support in complet-
ing this work. Rick Leyh’s excellent suggestions and support have been critical to my work.
Rick has provided superb leadership in this undertaking. In addition, Lari Bishop, Kris
Pauls and Camille McMorrow kept the production and development work on target. The
Wiley team, including Susan Elbe, Publisher, Leslie Kraham, Acquisitions Editor, and
Charity Robey, Senior Marketing Manager, was very supportive. Most important to me
was the exceptional work of my copyeditor and author of the Important Issues and some
of the Ethical Dilemma boxes, Christy Goldfinch. Christy has been more than a copyedi-
tor. She studied each topic and provided excellent questions and suggestions while ensur-
ing the simplicity and clarity of the text. Many thanks also to my daughter, Dalit Baranoff,
for her fine work on the test bank and the Ethical Dilemma boxes for Chapters 10 through
19, as well as for her support and additional suggestions as I wrote each chapter.
I would like to give special tribute and acknowledgment to all my students in my Risk
and Insurance and Employee Benefits classes at Virginia Commonwealth University for
their excellent work on projects similar to those featured in Cases 1 and 2. Special recog-
nition is given to Jessica Duke, a Spring 2002 student, who provided much of the research
and support for the e-commerce risk sections and the updates to the Social Security chap-
ter. Most important is the work of my graduate student Denise Togger, who wrote Case 4
as a special studies project and contributed large sections of Chapter 3.
In addition, important suggestions were made by a number of colleagues who took
their time to offer detailed comments on the book before its final revision. These review-
ers include:
Joan Lamm-Tennant, GeneralCologne Re Capital Consultants
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