FIN 3100 Ch 1-3 questions

What is the meaning of adverse selection?

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.

Define chance of loss.

the probability that a loss will occur

What is financial risk?

A risk that business firms face because of adverse changes in commodity prices, interest rates, foreign exchange rates, and the value of money.

Explain the meaning of enterprise risk.

A term that encompasses all major risks faced by a business, including pure risk, speculative risk, strategic risk, operational risk, and financial risk.

Briefly explain each of the following risk-control techniques for managing risk:

Avoidance: Loss prevention: Loss reduction: Duplication: Separation: Diversification:

What is enterprise risk management?

Comprehensive risk management program that considers an organization's pure risks, speculative risks, strategic risks, and operational risks.

Explain the Law of Large Numbers.

Concept that the greater the number of exposures, the more closely will actual results approach the probable results expected from an infinite number of exposures.

Explain the difference between a direct loss and an indirect or consequential loss.

Direct Loss: Financial loss that results directly from an insured peril. Indirect Loss: Financial loss occurring as the consequence of some other loss.

How does diversifiable risk differ from nondiversifiable risk?

Diversifiable risk: A risk that affects only individuals or small groups and not the entire economy, which can be reduced or eliminated by diversification. Nondiversifiable risk: A risk that affects the entire economy or large numbers of persons or groups within the economy, which cannot be reduced or eliminated by diversification. Also called systemic risk.

Why are most market risks, financial risks, production risks, and political risks considered difficult to insure by private insurers?

Insurance can be classified as either private or government insurance. Private insurance includes life and health insurance as well as property and liability insurance. Government insurance includes social insurance programs and other government insurance plans.

Identify the major risks faced by business firms.

Major risks faced by business firms include property risks, liability risks, loss of business income, cyber security and identity theft, crime exposures, human resources exposures, foreign loss exposures, intangible property exposures, and government exposures

How does objective risk differ from subjective risk?

Objective Risk: Relative variation of actual loss from expected loss, which varies inversely with the square root of the number of cases under observation. Subjective risk: Uncertainty based on one's mental condition or state of mind.

Identify the major social insurance programs in the United States.

Old-Age, Survivors, and Disability Insurance Unemployment insurance Medicare

What is the difference between peril and hazard?

Perils are events that bring about a loss, hazards are situations that increase the probability of a peril

Identify several property and casualty insurance coverages.

Personal lines Private passenger auto insurance Homeowners insurance Earthquake insurance Federal flood insurance Commercial lines Commercial auto insurance Workers compensation and excess workers compensation insurance Other liability insurance Product liability insurance Commercial and farmers multiple peril insurance Medical malpractice insurance Fire and allied lines insurance Accident and health insurance Inland marine and ocean marine insurance Surety bonds and fidelity bonds Mortgage guaranty insurance Financial guaranty insurance Burglary and theft insurance Boiler and machinery insurance Crop insurance Warranty insurance

Define physical hazard, moral hazard, attitudinal hazard, and legal hazard.

Physical hazard: Physical condition that increases the chance of loss. Moral hazard: Dishonesty or character defects in an individual that increase the chance of loss.

Identify some methods that insurers use to control for adverse selection.

Policy provisions underwriting

Explain each of the following characteristics of a typical insurance plan.

Pooling of losses: Payment of fortuitous losses: Risk transfer: Indemnification:

Explain the objectives of risk management both before and after a loss occurs.

Pre-loss Objectives Economy. This means that the firm should prepare for potential losses in the most economical way. This preparation involves an analysis of the cost of safety programs, insurance premiums paid, and the costs associated with the different techniques for handling losses. Reduction of anxiety. Certain loss exposures can cause greater fear and worry for the risk manager and key executives. For example, the threat of a catastrophic lawsuit because of a defective product can cause greater anxiety than a small loss from a minor fire. Having a risk management plan in place reduces fear and worry. Meeting legal obligations. For example, government regulations might require a firm to install safety devices to protect workers from harm, to dispose of hazardous waste materials properly, and to label consumer products appropriately. State laws mandate that workers' compensation benefits must be available to workers who are injured while at work. The firm must see that these legal obligations are met. Post-loss Objectives Survival of the firm. Survival means that after a loss occurs, the firm can resume at least partial operations within some reasonable time period. Continue operating. For some firms, the ability to operate after a loss is extremely important. For example, a public utility firm must continue to provide service. Banks, dairies, bakeries, newspapers, and other competitive firms must continue to operate after a loss. Otherwise, business will be lost to competitors. Stability of earnings. Earnings stability can be maintained if the firm continues to operate. However, a firm might incur substantial additional expenses to achieve this goal (such as operating at another location), and perfect earnings stability might be difficult to attain. Continued growth of the firm. A company can grow by developing new products and markets or by acquiring or merging with other companies. The risk manager must therefore consider the effect that a loss will have on the firm's ability to grow. Social responsibility. This is to minimize the effects that a loss will have on other persons and on society. A severe loss can adversely affect employees, suppliers, customers, investors, creditors, and the community in general. For example, a severe loss that shuts down a plant in a small town for an extended period can cause considerable economic distress in the local area.

Explain the difference between pure risk and speculative risk.

Pure risk: Situation in which there are only the possibilities of loss or no loss. Speculative risk: Situation in which either profit or loss are clear possibilities.

Identify the approaches that insurers can use to deal with the problem of catastrophic loss exposures.

Reinsurance is an arrangement by which the primary insurer that initially writes the insurance transfers to another insurer (called the reinsurer) part or all of the potential losses associated with such insurance. insurers can avoid the concentration of risk by dispersing their coverage over a large geographical area. catastrophe bonds, which are designed to help fund catastrophic losses

Briefly explain each of the following risk-financing techniques for managing risk:

Retention: Risk management technique in which an individual or a firm retains part or all of the losses resulting from a given loss exposure. Used when no other method is available, the worst possible loss is not serious, and losses are highly predictable. Noninsurance transfers: Various methods other than insurance by which a pure risk and its potential financial consequences can be transferred to another party—for example, contracts, leases, and hold-harmless agreements. Insurance: Pooling of fortuitous losses by transfer of 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.

Explain the following risk-financing techniques.

Retention: means that the firm retains part or all of the losses that can result from a given loss. Noninsurance transfers: methods other than insurance by which a pure risk and its potential financial consequences are transferred to another party. Insurance:

Identify the sources of information that a risk manager can use to identify loss exposures.

Risk analysis questionnaires and checklists. Questionnaires and checklists require the risk manager to answer numerous questions that identify major and minor loss exposures. Physical inspection. A physical inspection of company plants and operations can identify major loss exposures. Flowcharts. Flowcharts can trace the flow of raw materials (the supply chain), production, and the distribution of products. A flowchart might reveal bottlenecks and areas where losses could occur and cause financial harm for the firm. Financial statements. Analysis of financial statements can identify the major assets that must be protected, financial obligations of the firm, loss of income exposures, key customers and suppliers, and other important exposures. Historical loss data. Historical loss data can be valuable in identifying major loss exposures.

What is systemic risk?

Risk of collapse of an entire financial system or financial market due to the failure of a single entity or group of entities, which can result in the breakdown of the entire financial system.

Describe the steps in the risk management process.

Step 1:Identify loss exposures. Step 2:Measure and analyze the loss exposures. Step 3:Select the appropriate combination of techniques for treating the loss exposures. Step 4:Implement and monitor the risk management program.

What is the difference between the maximum possible loss and probable maximum loss?

The maximum possible loss is the worst loss that could happen to the firm during its lifetime. The probable maximum loss is the worst loss that is likely to happen.

Describe the major social and economic burdens of risk on society.

The size of an emergency fund must be increased. Society is deprived of certain goods and services. Worry and fear are present.

Explain the historical definition of risk.

There is no single definition of risk. Historically, many insurance authors have defined risk in terms of uncertainty. Risk is uncertainty concerning the occurrence of a loss.

Pure risks ideally should have certain characteristics to be insurable by private insurers. List the six characteristics of an ideally insurable risk.

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.

What is the meaning of risk management?

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

What are the two major differences between insurance and hedging?

an insurance transaction typically involves the transfer of pure risks because the characteristics of an insurable risk generally can be met. moral hazard and adverse selection are more severe problems for insurers than for speculators who buy or sell futures contracts.

What is a loss exposure?

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

Explain the basic characteristics of social insurance programs.

are government insurance programs with certain characteristics that distinguish them from other government insurance plans.

How does enterprise risk management differ from traditional risk management?

enterprise risk: Comprehensive risk management program that considers an organization's pure risks, speculative risks, strategic risks, and operational risks. risk management: Systematic process for the identification and evaluation of loss exposures faced by an organization or individual, and for the selection and implementation of the most appropriate techniques for treating such exposures.

What are the two major differences between insurance and gambling?

gambling creates a new speculative risk, whereas insurance is a technique for handling an already existing pure risk. gambling can be socially unproductive, because the winner's gain comes at the expense of the loser.

Explain the meaning of risk financing.

risk financing refers to techniques that provide for the payment of losses after they occur.

Explain the following risk-control techniques.

Avoidance: means a certain loss exposure is never acquired or undertaken, or an existing loss exposure is abandoned. Loss prevention: refers to measures that reduce the frequency of a particular loss. Loss reduction: refers to measures that reduce the severity of a loss after it occurs. Duplication: refers to having backups or copies of important documents or property available in case a loss occurs. Separation: means dividing the assets exposed to loss to minimize the harm from a single event. Diversification: refers to reducing the chance of loss by spreading the loss exposure across different parties (for example, customers and suppliers), securities (for example, stocks and bonds), or transactions.

Identify the major fields of private insurance.

Life Insurance Health Insurance Property and Liability Insurance

Identify the major types of personal risks that are associated with economic insecurity.

Premature death Retirement risks Poor health Unemployment Alcohol and drug addiction

Explain the meaning of risk control.

a generic term to describe techniques for reducing the frequency or severity of losses. Major risk-control techniques include the following: