Hi. In today's presentation we're going to pick up with our understanding of the path to financial security. As you recall we began this class by talking first about how the importance of cash and credit management and the importance of building wealth for the known future that we want to have. But we also talked about things like cat bites and other things that can get in the way. That really introduced an element of uncertainty to us, for the types of resources and the risks our resources face. So we're going to focus now thinking a little bit about a family risk management. Now, what is risk then, when we think of families? Well, to put it bluntly, it's uncertainty. In other words, there's a chance for loss that a family may have happen. So, we're going to focus then first on basic principles of risk management, some simple decision rules that we have to follow. And then we'll think a little bit about key characteristics of various policies. In further sessions, we'll then talk a little bit more about insurance specifics, learning a little bit more about the types of insurance that are out there, and how we make choices within those policies. So let's begin by saying, how do we deal with risk? Well the first thing is we have to identify the risks that we face. So what types of risks do families and individuals face? Well, we face risks to our bodies, we face risks related to our ability to earn income, and we face risks related to our stuff. Whether or not something happens to them, happens to our things, someone takes them from us, they break, so on and so forth. We also have to think about what the potential loss is to a family. So if we think about our own health or we think about our own ability to work, what types of losses would that represent to my household if I became sick? Or if I died, what would that mean financially to my family. So not just the loss incurred, but the chances of it happening then too. Because certainly some losses can be catastrophic to a family, but they're not very likely to happen. So we have to put those two pieces together, as we start thinking about decisions. And then we choose a method with which to avoid, to deal with it. The first is, we can avoid the risk. So, for example, I'll use some common examples we can think about, lets say that we're concerned about the, the injury happening to us from riding a motorcycle. Well, the first thing we could do is, we don't ride a motorcycle. But that may not be exactly what we want in life, so we could avoid it. We could reduce, or mitigate the loss that we have. So, for example, we could wear a helmet. We could drive the speed limit. We could not drive on rainy days. There's lots of things we can do to reduce the potential loss from occurring without entirely avoiding an activity. We can simply assume the risk. Where we have money saved up, if something happens to our motorcycle, we then can purchase a new one. If we injure it, we have money saved up to deal with health care costs. So we simply assume that risk ourselves, whatever would happen to us. And lastly, we can share that risk or transfer it to someone else. We can ask them to deal with the financial loss of a particular event occurring for us on our behalf. And so, this idea of sharing the risk with somebody else, or partially transferring it to them, is what we often think of as being insurance. So the types of risks then that we deal with in life, pure risk. Number one, this would be that there's only a chance of loss if a specific thing occurs. In other words, if a fire occurs, damage is going to be done. How much that damage is, that's a whole other issue, but in other words if a fire occurs there really isn't a chance for gain. Speculative risk on the other hand is, can have a loss or a gain. So we can think of this as gambling, or in some ways we can equate to investing although we don't equate investing to gambling. Sure risk, though, is what's insurable, right? So we can insure against something that only brings us the chance of loss. It's hard to insure against something that actually could have a chance of gain for us. So, again, this idea of pure risk versus speculative risk, helps us in our mind to think of what do we manage, how do we deal with it? When also we think about risk, we want to think about subjective risk, versus objective risk. So, subjective risk is kind of this idea of our perception of it. We don't think it's likely to happen to us. We ca, or we think it's too likely to happen to us. Objective risk relies more upon the facts themselves. How likely does this happen in general to people, and ergo, what's the likelihood that it happens to me. So, how we think about risk, right, how often we think something's going to happen, is going to influence our decision making. So our subjective assessments may be somewhat biased, based upon our own life experiences or the experiences of those close to us. So we certainly want to consider what our gut tells us, but we don't want to ignore the cold, hard facts either. So what types of perils do we face? Well, we mentioned number one things that can affect our income potential, dying too young, living too long, accidents and illness. All of which can sort of affect our income itself. If we die too soon, that actually is going to affect our families. If we get sick or injured and are unable to work, we refer to this as disability. Then that eliminates our ability to earn income, at least potentially what we were earning before. And of course living too long is this whole other issue which means, right, that we don't have enough money to spend or to meet our spending needs over our lifetime. The other type of peril we face, is things that affect our stuff, or wealth if you will. This can be property damage, or more importantly, liability for injuries that we've inflicted on others. So for example, we may have hurt someone else, or someone else may have been hurt by our action or inaction, for that matter. And as a result, we may be liable, for damages done to that individual. That damage that's done to them, can cost us from our wealth pile if you will. So, how do we choose? What types of decisions do we employ for this? So let's first of all think about the things that are very likely to happen. This is what we mean by high frequency, meaning that they occur somewhat regularly. So, on one hand, right, we call this a basic two by two matrix. We have across the top high frequency, low frequency. How likely it is to happen, how unlikely it is to happen, right? High frequency means it happens often, low frequency, not so often, more of a rare event. High severity means, if it happens, it's going to cost us dearly. It's going to represent a large loss to a family. And if it's low severity it means that if it happens, the loss is not going to be too substantial for us. So, right, this could be bumps and bruises on a playground or from riding a bike, right, versus things like, for example, bungee jumping without a helmet. So high severity, low severity. So, let's think about how we manage this, if it's very likely to happen to us, right, meaning that if we engage in this activity there's a high chance that we're going to have a loss associated with it, and if that loss occurs it's going to be serious in nature we're probably best off to avoid that. Okay? If it's high frequency but low severity, meaning that it happens a lot, but when it happens it's not a big deal, then we probably want to take odds to reduce or retain that particular loss. So what are examples of that? Well, let's say that you play sports. So, there's a high frequency that little injuries occur, most of the injuries are bumps and bruises, maybe a broken bone, but many not life threatening in nature, thank goodness. So we might, for example, wear protective equipment while we're playing those sports, wear helmets. Things like that, for example, to help reduce the potential risk that's going to happen to us. But realizing that if we just our other choice would simply be to not engage in the activity. Well for a lot of us not engaging in sports is would really not be our first choice. What about things then are on the other side of the spectrum. Low frequency for example? Well, if it's very severe, that's where insurance comes in. Right, so, again, it doesn't happen often, if it does, it's pretty severe, like a car accident itself. So, these don't happen often to us, hopefully when they do though, there's typically a reasonable sense of loss for it, even a fender bender can generate several thousand dollars of loss for a family. So, in that case, that's where we want to engage in transferring the risk to an individual, or to an insurance company, is more the point,. We want them to take on the potential financial loss associated with that event. And we'll potentially be willing to pay some portion of that. And we'll learn more and more how that becomes part of the picture. If it's low frequency and low severity, we're going to probably just want to retrain that. Doesn't happen often, and when it does, it's no big deal. That's something that probably is not worth trying to insure. Potentially not going to invest a lot in trying to reduce, so we're just probably going to assume that risk itself. So, this represents sort of a way in which we can think about how families could consider dealing with risk management. How they might make certain decisions about it. So what causes loss for families? Well, we've talked about injuries and illnesses, let's think about some of the other causes of loss. A peril is the cause of the loss. For example, a tornado or a fire, these are things that directly cause a loss. A hazard on the other had, is a condition that increases the likelihood of a loss occurring. Now these are really important kind of things and there's real distinctions. Hazards can be physical. They're not even always accidental. For example, we have a concept called a moral hazard. A person is not motivated to avoid this, sorry, morale hazard. They're not motivated to actually avoid this. So, they're not necessarily going to put things tightly on containers that are flammable, but they're also not going to leave open lit items next to an open container. A moral hazard on the other hand, the individual can actually cause the peril. They're going to do more directly causing the loss. Things like arson, for example. There's accidental fires, and then there's fires that are set by individuals being purposely careless to try and make that happen. So, hazards increase the likelihood that a loss is going to occur. What about being sick? Is being sick a hazard or a peril? And in fact, it's one of the things that he says represents a little bit of both. Certainly being sick directly causes a little bit of a loss to us financially. But in addition, we know that some illnesses will actually make it more likely that someone gets some other type of illness, some other type of problem associated, a complication if you will. So, illness, for example, can be both a direct cause of loss and increase the chances that more loss occurs. So some things will be both perils and hazards, which is kind of an interesting way to think about it. Now what about these perils that we have? Well, we're going to learn a little bit about what makes something insurable versus not insurable. The first thing to know is one of the rules of insurances is adverse selection, and what this really means is that the more likely is that you're going to need something, that you're going to need an insurance payment for something. The more expensive that insurance is going to probably be. Now what's an example of this? If you live on a fault line, right, then obtaining earthquake insurance is going to be very expensive. If are, for example, you don't live on a fault line, live very far away from one. No history of earthquakes whatsoever in your area. Then earthquake insurance is probably very cheap. Not sure why you would potentially need it, but the fact is it would be very cheap if you got it. So the idea is that this has to be the case, because imagine for a moment, if insurance companies didn't follow this principle, how could they possibly afford to pay out for those many losses that would occur, when any type of natural disaster would happen? So for example, obtaining hurricane insurance in Florida is also a very costly proposition. So, this issue of adverse selection really represents part of a survival mechanism for insurance companies themselves, but is absolutely reflected in pricing and insurability. So what's insurable then? Well, number one, there has to be a large number of alike units that are exposed to the same issue. So, this for example, could be a lot of people working in the same type of job. This could be a lot of cars, that drive in the same city. So that's part of it, that we have to have enough people, that they can use statistics to have some predictability about how much loss is likely to occur. In the amount of people they insure. The other thing is that insured losses, absolutely have to be accidental in nature. Remember we talked about moral, moral hazard, and of course physical hazards. These have to have been accidents. If we're causing the perils, if we're causing the losses, insurance companies right again, couldn't afford to stay in business. Insured losses must be measurable. We may think that certain things in our lives are priceless, but unfortunately, an insurance company can't write a check for priceless. So, some level of measurability for what the loss is, and we could say the loss of a life is priceless, or immeasurable. That's why it's often based upon how much income they produced or the services they provided a family. Losses can't be catastrophic for an insurer either. Again, adverse selection. If the losses would be such a weight that the insurance company goes bankrupt, people won't get paid. So, insurance companies have to really kind of build their plan, such that they're not taking on so much risk themselves, that they couldn't afford it if a particular event occurred. And of course the premiums have to be affordable. In other words, what they're going to charge a consumer also have to be affordable, or else again, it doesn't quite work. If I had to pay so much for insurance that I'd be better off just putting the money in my own savings account. In case the event occurs, that again kind of creates a problem for insurance companies. So we'll see, right, that a lot of times as you're pricing insurance you'll see some of these forces at work. So, we're going to see that while we're going to get knee deep into specific types of insurance, we want to think about the nature of a contract itself. So the first thing is that for a contract to be valid with respect to insurance. They have to be an offer and an acceptance. In other words, an insurance company offers to say we will provide a level of coverage for this price and the consumer says, yes, I'll take that on. There has to be legal competency for all parties. So, for example, minors, those on drugs or alcohol, abusing substances. Can't usually engage in a lawfully biding contract. Yet there has to be a lawfully biding contract for someone to be insured. So this may be the case where people are on their parent's insurance if they're still minors as well. There has to be some sort of legal consideration for services. So we talked about offering acceptance. That has to, in other words, involve a premium payment or a promise to cover losses. In other words, everybody's getting something out of the arrangement. And in addition, lawful purpose. Insurance contracts can't be written in such a way that they actually encourage illegal behavior. So for example, we could not insure someone who might be selling illegal items. And say that these items are insured in the event of a fire, because those items are illegal to be selling in the first place. So again, the contract itself can't validate something that's an illegal process itself. So, a few other key things to think about, is that the insured and the insurer, honest and forthcoming. So, when you engage into an insurance company relationship, you've gotta be upfront and honest. The problem with omitting or potentially telling little lies while you're getting into a contract, you may think I'm going to save a little bit of money on my premium. However, if those laws are discovered when you make a claim, then it actually means they may deny you the claim in the first place, and say this isn't valid because you lied in the first place. So, that type of utmost good faith really has to be kept in, kept as, kept in mind. A warranty is a promise made from the insured to the insurer. It doesn't necessarily hold for all statements made on an application, but may actually be documented promises that you make. You can also know that statements that you make during an application process, may actually be recorded. And in fact if you ever called in to question about insurance company, you will inevitably get the, this conversation maybe recorded for protection of our parties. So, you'll find that most of the time those conversations are recorded as a result. And even concealment, the omission of something is still problematic. So, the fact that were silent about something that's a material fact,. Doesn't mean that it's okay. You may think it's different than telling a lie, but it's still a lie by omission. A few other types of things too, and one of the reasons why we know that insurance benefits, if you think back to our discussion on taxes, insurance payouts are not taxable, and that's because insurance payouts are only up to the amount of a loss. We're not getting more than what we had before. We're, at best, being restored to where we were before our loss. We call this the principle of indemnity. In addition, we also can't sue on our behalf if we're getting payments from our insurance company as well. The insurance company will do that lawsuit for us. They refer to that as the right of subrogation, of course. And lastly, the principle of insured interest. The idea that if you're buying an insurance contract, let's say on a person, then there has to be some emotional or financial loss. In other words you have to have some level of insurable interest. We can't just buy life insurance on someone who's wealthy and very, very sick. And say when they die, I want to get money for that, we have to have some reason that we were actually dependent upon their money in the first place. So, we don't just buy insurance on stranger's lives, right? We have no insurable interest as a result. So contracts will also potentially exclude certain things. They may not include pets. Homeowner's Insurance may not include parts of the home that are used for business purposes. Contracts can also have riders, and endorsements, these are going to be specifically documented written additions, that modify the policy, provide you for additional coverage something specific that you wanted. And a few types of things as you might see this is how lost is themselves evaluated you can for example pay extra to have a replacement cost in other words, what would it take to buy that item today it's what you're going to get for your insurance pay out. That cost you more money for example than you're actual cash value, which we can think of as the depreciated value. In other words, what is something worth today given what it was worth when you bought it, whatever time that was. And so, we'll look at an example of that mathematically as well. And lastly, there can be agreed upon value. What we all say something is worth. And again, much like replacement cost, this may cost a little bit extra as well. And this is the case for things that might be artwork. Classic what we might call collectors items. Let's say you have a collection of cars or such that all have some value associated with them, you want potentially that to be the value if you will that's insured in the event of a loss. So, determining actual cash value this is straight line depreciation is the way to think about it. So, ACV is actual cash value. This is going to be equal to the purchase price, minus the current age of something times the frat, the ratio of the purchase price to the life expectancy. So in other words, how long have we had something, subtract that from the price. So, we account for the amount of depreciation if loss of value that we have from owning something after a while. So a simple example of this, Bud Bundy has his four year old TV stolen from his apartment. The TV cost him $450, and had a life expectancy of ten years. What was the actual cash value? Well, in this case its $270, right? So, 450 minus the number of years he's had it. Right? Given the price divided by the number of the life expectancy for the product. So $450, right, minus that mess, equals $270. So as we said before, this is really just straight line depreciation is one way we think about it. You may use alternate forms of depreciation, to get to an agree upon value of something as well. So, some last minute things then as we start thinking about what are the primary things for contract features. Well number one is what is it that you are responsible for. We said before that insurance is really about risk sharing, as opposed to really just risk transfer and the sharing of that comes in several forms. Number one was the premium. We pay them regularly to have this protection. When they also have a deductible, in other words, when a loss occurs, we're responsible for the first 1000, the first $5000 of the loss, and the insurance company will make payments after that. So, for example this could be anything, and the lower our premium, the lower our premiums are, usually the higher the deductible, the lower our deductible, right, the higher the premiums. So, in other words, what percentage of the loss or what dollar amount of the loss are we promising to take on before the insurance company has anything. And that's because if you think about it, a lot of losses may be small dollar items, where given a deductible, let's say on your homeowner's policy of $5,000, the insurance company might not actually have to pay out all the time, because you're responsible for that first amount of money. So, if a water pipe burst in your house, had $1,000 or $2,000 worth of damage, you may not even file a claim for it because the insurance company won't be giving you any money towards it. There's a few other things too, co-payment this is when an insurer pays a specific amount of the loss plus a deductible. These are given the dollar amounts. And then we also have coinsurance, which goes hand in hand with deductibles as well. And this is the percent of financial responsibility for each party, the insured and the insurer. So, for example, we could look at a homeowner's policy that has a $5,000 deductible, and a 20% coinsurance. You're responsible for the first $5,000 of the loss. Plus 20% of the amount over that $5,000. That's a typical model we might see for a lot of homeowner's policies, or even auto policies as well. So let's summarize, households fake, face unique risks. Risks to their bodies, risks to their earning potential and risks to their stuff. We've seen then that, given the nature of the risks that we might be facing, the frequency that we might face them, and of course the severity that they might be, that we have different choices in our risk management. So make sure that you review that, and think a little bit about in which situations does it make sense to transfer risk, to assume risk, to avoid risk. Try and think of your own life when you're using insurance and when you're not. What risks do you accept, and have you put them through this type of thought process? We'll be focusing next on the different types of insurance policies that are out there, and learning more about how we make choices for each one of those.
