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Foundations of Actuarial Science
MATH 3620, Section 2
CLASS 1
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Class 1 - Overview
• Introductions
– About Me
– About You – Complete the “Getting to Know You” questionnaire
• HuskyCT – Everything runs through HuskyCT
• The Course
– Expectations
– Syllabus
– Grading
• Chapter 1 Overview: Intro to Risk
• Homework Assignment
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My Goal and Expectations
• My goal for this class - Prepare you for your future careers
– Help you gain an understanding of the nature of risk, insurance as a
tool for managing and financing risk, and how actuaries are involved
– Relate material to the world in which you will work
• My expectations of you:
– Act honestly and with integrity
– Read the assigned material prior to the class
– Complete the homework assignments
– Ask questions / contact me if you’re having trouble with a concept or
problems
– Participate in class
– Communicate - Let me know what’s working and what isn’t
– Interactions
▪ How I ask questions
▪ Class participation
▪ Office hours
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Society of Actuaries Candidate Code
of Conduct
• The purpose of the Society of Actuaries (SOA) Code of
Conduct for Candidates (“Candidate Code”) is to require
Actuarial Candidates to adhere to the high standards of
conduct, practice, and qualifications of the actuarial
profession, thereby supporting the actuarial profession
in fulfilling its responsibility to the public.
• RULE 1: An Actuarial Candidate shall act honestly, with
courtesy, integrity, and competence, to uphold the
reputation of the actuarial profession.
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About You
• Please complete the Getting to Know You Questionnaire
under Assignments on HuskyCT by class on Thursday
▪ 10 Questions
▪ Important to help me understand who you are and the make up of
the class overall
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HuskyCT
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Course Information
• Syllabus/Course overview – gives more detail about various
topics
– The Text (new this semester): Principles of Risk Management and
Insurance - Rejda and McNamara (Thirteenth Edition)
– Calculator
– Office hours – MONT 124; 6 PM before class
– Testing
– My contact information – michael.grandpre@uconn.edu
– Course objectives
– Listing of each class by date and what is to be covered and graded
assignments
▪ Actual due date for graded assignments will be given during class when these
are assigned in class and noted with assignment in HuskyCT
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Grading
• Exams
– Two Mid Term Exams – material covered since last exam
– Final Exam - cumulative
• Company Risk Analysis
• Assignments
– Multiple assignments during the semester through which you can apply
the concepts of risk management to specific problems
• Homework – textbook problems
– Not graded
– Assigned after material is covered in class
– Solutions are posted on HuskyCT
• Honors Conversion Credit
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Grading/Assessment
25% Graded Assignments
10% Company Risk Analysis project
20% 1st Midterm Exam
20% 2nd Midterm Exam
25% Comprehensive Final Exam
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Syllabus Overview
What are we covering in this class?
• Learn about risk (in general and specific to insurance
companies)
• Learn life, health and property-casualty products and
the role of the insurance regulators
• How risk is managed and specifically how insurance
companies manage risk and make money
• The roles of actuaries
– Pricing
– Reserving
– Risk Management
– Capital Management
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Syllabus Overview
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Principles of Risk Management and
Insurance
Thirteenth Edition
Chapter 1
Risk and Its
Treatment
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Agenda
• Definitions of Risk
• Chance of Loss
• Peril and Hazard
• Classification of Risk
• Major Personal Risks and Commercial Risks
• Burden of Risk on Society
• Techniques for Managing Risk
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What is Risk?
A situation is riskier than another when:
1. there is greater expected loss
Example: Chance of losing $5 versus chance of losing $50,000
2. there is greater variance (less predictability) of outcomes
Example: Chance of falling off a bike that has training wheels versus no training
wheels
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Risk is Costly
Greater risk imposes costs (reduces value)
• Example 1:
– Two identical properties:
▪ Both worth $100k initially
▪ One suddenly at 10% risk of total loss
The second house now has greater risk than the first; its
value is less.
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Risk is Costly
Greater risk imposes costs (reduces value)
• Example 2:
– Two identical properties:
▪ First worth $90k, with 0% risk of loss
▪ Second otherwise worth $100k, but 10% chance of total loss.
While the expected value of the two properties is identical, the
second property is perceived as “riskier” because there is
greater uncertainty in its estimate.
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Definitions of Risk (1 of 2)
• Traditional Definition of Risk: Uncertainty concerning the
occurrence of a loss
• In the insurance industry, risk is also used to identify the
property or life that is being considered for insurance
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Definitions of Risk (2 of 2)
• Loss Exposure: Any situation or circumstance in which a
loss is possible, regardless of whether a loss occurs
• Objective risk is defined as the relative variation of actual
loss from expected loss
– It can be statistically calculated by some measure of
dispersion, such as the standard deviation
• Subjective (perceived) risk is defined as uncertainty
based on a person’s mental condition or state of mind
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Chance of Loss
• Chance of loss: The probability that an event will occur
• Objective probability refers to the long-run relative
frequency of an event based on the assumptions of an
infinite number of observations and of no change in the
underlying conditions
• Subjective probability is the individual’s personal
estimate of the chance of loss
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Chance of Loss vs. Objective Risk
• Chance of loss is the probability that an event that causes
a loss will occur.
• Objective risk is the relative variation of actual loss from
expected loss
The chance of loss may be identical for two different groups,
but objective risk may be quite different!
City # homes
Average #
fires Range
Chance of
Fire
Objective
Risk
Philadelphia 10,000 100 75 – 125 1% 25%
Los Angeles 10,000 100 90 – 110 1% 10%
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Peril
• A peril is defined as the cause of the loss.
– Examples include property damage because of fire,
windstorm, or lightening, or damage to your car
because of a collision with another vehicle.
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Hazard
• A hazard is a condition that increases the chance of loss
– A physical hazard is a physical condition that
increases the frequency or severity of loss
– Moral hazard is dishonesty or character defects in an
individual that increase the frequency or severity of
loss
– Attitudinal Hazard (Morale Hazard) is carelessness
or indifference to a loss, which increases the frequency
or severity of a loss
– Legal Hazard refers to characteristics of the legal
system or regulatory environment that increase the
frequency or severity of losses
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Classification of Risk
• Pure Risk and Speculative Risk
– A pure risk is a situation in which there are only the
possibilities of loss or no loss (earthquake)
– A speculative risk is a situation in which either profit
or loss is possible (investment or gambling)
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Classification of Risk
• Diversifiable Risk and Nondiversifiable Risk
– A diversifiable risk affects only individuals or small
groups (car theft). It can be reduced or eliminated by
diversification.
– A nondiversifiable risk affects the entire economy or
large numbers of persons or groups within the
economy (hurricane). It is also called fundamental risk.
▪ Government assistance may be necessary to insure
nondiversifiable risks.
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Classification of Risk
• Systemic risk is the risk of collapse of an entire system or
entire market due to the failure of a single entity or group
of entities that can result in the breakdown of the entire
financial system
– Systemic risk is especially important with respect to large
financial institutions that are considered too large to fail
without doing major financial harm to the US economy
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Major Commercial Risks for Businesses
• Property
• Liability
• Loss of Business Income
• Cybersecurity
Pure Risk
• Investments
Speculative Risk
• Uncertainty in firm’s financial goals & strategy
Strategic Risk
• Risk Related to how the company executes
Operational Risk
• Changes in interest rates, prices, foreign exchange rates
Financial Risk
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Major Personal Risks for Individuals
• Premature Death
• Longevity
• Health
• Unemployment
Personal Risks
• Destruction or theft of property
Property Risks
• Legal liability for injury or property damage to someone else
Liability Risks
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Direct vs Indirect Loss
– A direct loss is a financial loss that results from the
physical damage, destruction, or theft of the property,
such as fire damage to a home
– An indirect loss is a financial loss that results
indirectly from the occurrence of a direct physical
damage or theft loss (e.g., the additional living
expenses after a fire).
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Burden of Risk on Society
• The presence of risk results in three major burdens on
society:
– Cost
▪ In the absence of insurance, individuals and business
firms would have to maintain large emergency funds to
pay for unexpected losses or risk bankruptcy
– The risk of a liability lawsuit may discourage
innovation, depriving society of certain goods and
services
– Risk causes worry and fear
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Techniques for Managing Risk
Risk Control
• Avoidance
• Loss prevention
• Loss reduction
• Duplication
• Separation
• Diversification
Loss Financing
• Insurance
• Noninsurance
transfers
• Retention
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Techniques for Managing Risk
• Risk Control refers to techniques that reduce the
frequency or severity of losses:
– Avoidance
– Loss prevention refers to activities to reduce the
frequency of losses
– Loss reduction refers to activities to reduce the
severity of losses:
▪ Duplication
▪ Separation
▪ Diversification
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Techniques for Managing Risk
• Risk Financing refers to techniques that provide for
payment of losses after they occur:
– Retention means that an individual or business firm
retains part or all of the losses that can result from a
given risk.
– Active retention means that an individual is aware of
the risk and deliberately plans to retain all or part of it
– Passive retention means risks may be unknowingly
retained because of ignorance, indifference, or laziness
▪ An unknown risk is still a risk; failure to identify the risk is
an implicit decision to retain
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Techniques for Managing Risk
• Self Insurance is a special form of planned retention by
which part or all of a given loss exposure is retained by the
firm
• A Noninsurance transfer transfers a risk to another party.
– A transfer of risk by contract, such as through a hold-
harmless clause in a contract
– Hedging is a technique for transferring the risk of
unfavorable price fluctuations to a speculator
– Incorporation of a business firm transfers to the
creditors the risk of having insufficient assets
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Why Insurance?
• For most people, insurance is the most practical method
for handling major risks:
– Risk transfer is used because a pure risk is transferred
to the insurer.
– The pooling technique is used to spread the losses of
the few over the entire group
– The risk may be reduced by application of the law of
large numbers
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Assignment – Next Class
1. Read Chapters 1 and 2
2. Complete the “Getting to Know You” questionnaire -
due before the beginning of our next class
3. Homework: Answer Review Questions 1 – 3, 11 and
Application Question 2 at the end of Chapter 1
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