The Big Study Guided

risk transfer

- means that a pure risk is transferred from the insured to the insurer, who typically is in a stronger financial position to pay the loss than the insured .

Objective risk

- (also called degree of risk) is defined as the relative variation of actual loss from expected loss .-

Funded Reserve

- A funded reserve is the setting aside of liquid funds to pay losses. A self- insurance program (discussed later) that is funded is an exam-ple of a funded reserve.

Costs of Insurance

- Cost of doing business ■ Fraudulent claims ■ Inflated claims

insurance vs hedging

- First, an insurance transaction typically involves the transfer of pure risks because the characteristics of an insurable risk generally can be met . However, hedging is a technique for handling speculative risks that may be uninsurable, such as protection against a decline in the price of agricultural products and raw materials. - A second difference between insurance and hedging is that insurance can reduce the objective risk of an insurer by application of the law of large numbers . As the number of exposure units increases, the insurer's prediction of future losses improves because the relative variation of actual loss from expected loss will decline.

pooling

- is the spreading of losses incurred by the few over the entire group, so that in the process, average loss is substituted for actual loss . - pooling implies (1) the sharing of losses by the entire group and (2) prediction of future losses with some accuracy based on the law of large numbers.

adverse selection

- is the tendency of persons with a higher-than-average chance of loss to seek insurance at standard (average) rates, which if not controlled by underwriting, results in higher-than-expected loss levels .

insurance vs gambling

- First, gambling creates a new speculative risk, while insurance is a technique for handling an already existing pure risk . Thus, if you bet $500 on a horse race, a new speculative risk is created, but if you pay $500 to an insurer for a homeown-ers policy that includes coverage for a fire, the risk of fire is already present. No new risk is created by the transaction. - The second difference is that gambling can be socially unproductive, because the winner's gain comes at the expense of the loser . In contrast, insur-ance is always socially productive, because neither the insurer nor the insured is placed in a position where the gain of the winner comes at the expense of the loser.

management process steps

- Identify loss exposures ■ Measure and analyze the loss exposures ■ Select the appropriate combination of techniques for treating the loss exposures ■ Implement and monitor the risk management program

Retention

- Retention is an important technique for managing risk. - Active risk retention means that an individual is consciously aware of the risk and deliberately plans to retain all or part of it. - Risk can also be retained passively. Certain risks may be unknowingly retained because of ignorance, indifference, lazi-ness, or failure to identify an important risk. Passive retention is very dangerous if the risk retained has the potential for financial ruin.

Objectives of Risk Management

- The first objective means that the firm should prepare for potential losses in the most economical way . - The second objective is the reduction of anxiety - The final objective is to meet any legal obligations - The most important post-loss objective is survival of the firm - The second post-loss objective is to continue operating - The third post-loss objective is stability of earnings - The fourth post-loss objective is continued growth of the firm . - Finally, the objective of social responsibility is to minimize the effects that a loss will have on other persons and on society .

Loss Prevention

- You try to reduce the probability of a loss as to reduce the frequency of losses example: taking a safe driver course, you are less likely to be in an accident.

Attitudinal (Morale) Hazard

- a carelessness or indifference to a loss - increases the frequency or severity of a loss Example: you leave your keys in the car and your car gets stolen

Hold-harmless clause

- a clause where the seller is not held accountable in the event of what they have sold malfunctions and causes some sort of injury

Hazard

- a condition that creates or increases the severity of loss. -includes Physical, Moral, Morale and Legal hazards

Indirect or Consequential Loss

- a financial loss that is created from the direct physical damage or loss.

Avoidance

- a technique for managing risk example: avoid the risk of divorce by never marrying, avoid drowning by never going in the water

Hedging

- a technique for transforming the risk of unfavorable price fluctuations to a speculator by buying and selling futures contracts on an organized exchange.

Incorporation

- another example of risk transfer - only allows investors to come after what a business is worth in the event of a down fall. They can't come after the personal possessions of the business owner

Loss Exposure

- any situation or circumstance in which a loss is possible, regardless of whether a loss occurs

Personal risks

- are risks that directly affect an individual or family . Premature death ■ Insufficient income during retirement ■ Poor health ■ Unemployment

Moral Hazard

- dishonesty or character defects in an individual that increase the frequency or severity of a loss.

fortutious losses

- is a loss that is unforeseen and unexpected by the insured and occurs as a result of chance . In other words, the loss must be accidental.

Physical hazard

- is a physical con dition that increases the frequency or severity of loss - Examples of physical hazards include icy roads that increase the chance of an auto accident,

Risk Management

- is a process that identifies loss exposures faced by an organization and selects the most appropriate techniques for treating such exposures.

Self-insurance

- is a special form of planned retention by which part or all of a given loss exposure is retained by the firm. Another name for self-insurance is self-funding, which expresses more clearly the idea that losses are funded and paid for by the firm.

Pure risk

- is defined as a situation in which there are only the possibilities of loss or no loss . - Examples of pure risks include premature death, job-related accidents, catastrophic medical expenses, and damage to property from fire, lightning, flood, or earthquake.

Premature death

- is defined as the death of a family head with unfulfilled financial obligations - These obligations include dependents to support, a mortgage to be paid off, children to educate, and credit cards or installment loans to be repaid.

Subjective risk

- is defined as uncertainty based on a person's mental condition or state of mind . For exam-ple, assume that a driver with several convictions for drunk driving is drinking heavily in a neighborhood bar and foolishly attempts to drive home.

Risk

- is defined as uncertainty concerning the occurrence of a loss - For example, the risk of being killed in an auto acci-dent is present because uncertainty is present. The risk of lung cancer for smokers is present because uncertainty is present. The risk of flunking a college course is present because uncertainty is present.

insurance

- is the pooling of fortuitous losses by transfer of such risks to insurers, who agree to indemnify insureds for such losses, to provide other pecuniary benefits on their occurrence, or to render services connected with the risk .

avoidance

- means a certain loss exposure is never acquired or undertaken, or an existing loss exposure is abandoned .

Retention.

- means that the firm retains part or all of the losses that can result from a given loss . Retention can be either active or passive. Active risk retention means that the firm is aware of the loss exposure and consciously decides to retain part or all of it, such as collision losses to a fleet of com-pany cars. Passive retention, however, is the failure to identify a loss exposure, failure to act, or forget-ting to act. For example, a risk manager may fail to identify all company assets that could be damaged in an earthquake.

indemnification

- means that the insured is restored to his or her approximate financial position prior to the occurrence of the loss . Thus, if your home burns in a fire, a homeowners policy will indemnify you or restore you to your previous position.

loss prevention

- refers to measures that reduce the frequency of a particular loss

Loss prevention

- refers to measures that reduce the frequency of a particular loss . For example, measures that reduce truck accidents include driver training, zero tolerance for alcohol or drug abuse, and strict enforcement of safety rules.

Loss Reduction

- refers to measures that reduce the severity of a loss after it occurs

Risk Financing

- refers to techniques that provide for the funding of losses

Risk control

- refers to techniques that reduce the frequency or severity of losses .

Loss Frequency

- refers to the probable number of losses that may occur during some given time period .

Loss Severity

- refers to the probable size of the losses that may occur .

Diversifiable Risk

- risk that only affects a few individuals or small groups but not the entire population - It can be reduced through diversification -(non-systematic)

Law of Large Numbers

- states that as the number of exposure units increases; the closer the predicted and actual loss will become.

Direct Loss

- the financial loss that results from the physical damage, destruction or theft of the property. Example : The cost of a new house after your house has burned

Property risks

- the risk of having property damaged or lost from numerous causes.

Financial Risk

- uncertainty of loss because of adverse changes in the financial market Example : bad interest rates, currency rates, poor stock returns, etc.

Benefits of Insurance

-Indemnification for loss ■ Reduction of worry and fear ■ Source of investment funds ■ Loss prevention ■ Enhancement of credit

Human Life Value

-Present value of the family's share of the deceased bread winners futures earnings. - one of the main costs of premature death

Chance of Loss

-The probability that an event will occur

insurable risk characteristics

-There must be a large number of exposure units. ■ The loss must be accidental and unintentional. ■ The loss must be determinable and measurable. ■ The loss should not be catastrophic. ■ The chance of loss must be calculable. ■ The premium must be economically feasible.

Legal Hazards

-characteristics of the legal system or the regulatory environment that increase the frequency or severity of losses. example: having a large number of jury members from the area that the victim in court is from

Enterprise risk Management

-combines all major risks faced by a firm into one package -overall risk is reduced - all risks cannot be perfectly correlated

Nondiversifiable risk

-is a risk that affects the entire economy or large numbers of persons or groups within the economy. - It is a risk that cannot be eliminated or reduced by diversification. -reduced by diversification. Examples include rapid inflation, cyclical unemployment, war, hurricanes, floods, and earthquakes because large numbers of individuals or groups are affected.

Peril

-is defined as the cause of loss - If your house burns because of a fire, the peril, or cause of loss, is the fire.

Enterprise Risk

-term that encompasses all major risks faced by a business firm. -includes pure risk, speculative risk, strategic risk, operational risk and financial risk

Liability Risks

-type of pure risk -no maximum upper limit in respect to the loss - you can be sued for any amount - a lien can be placed on your income check to satisfy a legal sentence

Credit Line

A credit line can be established with a bank, and borrowed funds may be used to pay losses as they occur.

Captive insurer

is an insurer owned by a parent firm for the purpose of insuring the parent firm's loss exposures . There are different types of captive insurers.

RIsk Retention Group

is an insurer owned by a parent firm for the purpose of insuring the parent firm's loss exposures . There are different types of captive insurers.

Speculative risk

is defined as a situation in which either profit or loss is possible . For example, if you purchase 100 shares of common stock, you would profit if the price of the stock increases but would lose if the price declines.

Loss reduction

refers to measures that reduce the severity of a loss after it occurs . Examples include installation of an automatic sprinkler system that promptly extinguishes a fire; segregation of expo-sure units so that a single loss cannot simultaneously damage all exposure units, such as having warehouses with inventories at different locations; rehabilitation of workers with job-related injuries; and limiting the amount of cash on the premises.

Risk Control

refers to the probable size of the losses that may occur .