FINA 456 Risk Management and Insurance Ch.4-6
As a result of a court decision, XYZ Company must pay a claimant $100,000 two years from today. What is the present value of the $100,000 award that XYZ Company must pay in two years? Assume a 10 percent interest (discount) rate.
$82,645 PV= 100,000/(1+.10)^2 = 82,645
Ch.5 Short answer question 2) The financial services sector in recent years has been characterized by consolidation and convergence. What is the meaning of these terms with respect to the financial services sector?
- Consolidation means that the number of firms operating in the financial services market has declined over time because of mergers and acquisitions. announcements of banks mergers and insurance company mergers have become commonplace. The obvious result is fewer, but on average larger, financial organization. - Convergence means that financial institutions can now sell a wide variety of products outside their core business area. Prior to the passage of the Gramm-Leach-Bliley (The Financial Modernization Act of 1999), a financial service company had limited ability to operate outside of its core area- banks concentrated on banking, insurers sold insurance, and securities firms handled investments. Today, we see convergence- For example, one large personal lines insurance companay now offers mutual funds, depository operations (banking), and extends mortgage loans.
Ch.4: Short answer question 9) What is capital budgeting? What does the net preset value (NPV) of a loss control investment represent to the owners of an organization?
-Capital budgeting is the analysis of investments in plant and equipment. Individual projects are analyzed to determine whether the project should be undertaken by considering the cost of the project relative to the benefit provided by the project. Only projects that will make the organization better-off (increase value) should be adopted. - NPV is one method of evaluating investment projects. The NPV of a project is equal to the present value of the future cash flow that the project will generate minus (-) the cost of the project. A loss control project may benefit the organization by reducing losses and by providing a cost reduction in insurance premiums. However, there is a cost involved if the loss control project is undertaken. As the present value of the future cash flow is "netted" against the cost of the project, The NPV demonstrates the value of the project to the owners of the firm.
Ch.4: Short answer question 7) Differentiate between (1) independent, (2) dependent, and (3) mutually exclusive events.
-If events are independent, the occurrence of one event has no impact upon the occurrence of the second event. A fire at a production facility in Toledo has no impact upon whether a fleet vehicle will de damaged on a highway in Arizona. - If events are dependent, then the occurrence of one event can effect the occurrence of the second event. For example, if two buildings are located close together, the probability of the second building having a fire loss is greater if there is fire at the first building. - If events are mutually exclusive, the occurrence of one event means that the second cannot occur. For example if you have a small tract of land, it may only be large enough for one business. Building a gas station on the property precludes building a retirement home on the land, and vice versa.
Ch.4: Short answer question 4) How do (1) the level of surplus and (2) investment income impact the underwriting cycle?
-The level of surplus is the key determinant of underwriting cycle. When insurers are in a strong surplus position, they are able to withstand underwriting losses. Companies can lower premiums and loosen writing standards. If underwriting is unprofitable, these companies can drawn upon the strong surplus position. A surplus is depleted through underwriting losses, a point may be reached where the company can longer tolerate underwriting losses. At that time, premiums, underwriting are raised and stricter underwriting is employed. As a better business in written at higher premiums, underwriting profits are generated and the surplus is restored. -Underwriting profits and losses do not occur in isolation. Investment income must also be considered. Insurers can lose money on underwriting and remain viable if there is sufficient investment income. Therefore, investment returns and anticipated investment returns have an impact upon the insurance marketplace. Insurers must charge higher premiums and employ tighter underwriting if they do not anticipate enough investment income to offset underwriting losses. Likewise, insurers can lower premiums and employ loose underwriting standards if anticipated investment returns will offset underwriting losses.
Ch.6: Short answer question 10) Why does an insurance company need a legal department?
A legal department is needed by private insurers for a number of reasons. As part of the liability coverage provided to the insured, the insurer may agree to provide legal defense. Lawyers are needed to review policy forms before they are introduced, to review advertising copy, and to provide legal advice regarding taxes, marketing, insurance laws, and investments. In addition, lawyers are needed to help collect subrogation recoveries.
Ch.4: Short answer question 10) What is the risk management information system (RMIS)?
A risk manager information system (RMIS) is a computerized data base that a risk manager uses to store and analyze the risk management data. The database can be use to prepare reports and to predict future loss levels. Such systems are marked by a number of vendors, or an organization may develop its own RMIS in-house.
Ch.6: Short answer question 1) What is the role of actuaries? Why is their job more difficult than pricing products in other industries?
Actuaries are ratemakers- they determine the premium to charge for insurance coverage. The pricing of insurance is more difficult than pricing products in other insurance. With other products, the cost of goods sold is known in advance. With insurance, the cost is not known until total losses and expenses are known, which may be months or years in the future.
Ch.5 Short answer question 4) How does an advance premium mutual differ from an assessment mutual?
Advance premiums mutuals charge a premium up-front that is expected to be sufficient to pay all claims and expenses. If premiums are not sufficient, any deficit is made up through the surplus of the organization, which is the difference between the insurer's assets and liabilities. Assessments mutuals reserve the right to levy an additional charge against policy-owners if the premiums originally charged are not sufficient to cover claims and expenses.
Ch.5 Short answer question 6) What are the differences between insurance agents and brokers?
An insurance agent is someone who legally represents an insurer and has the authority to act on the insurer's behalf. Brokers legally represent insurance buyers who are seeking coverage. Brokers don't have authority to bind an insurer. Both agents and brokers are compensated through commissions.
Ch.5: Case Applications Case #1: For many years, Sarah Jane was a successful independent insurance agent. Recently, she was recruited by two insurance companies. With the first company, Sarah Jane would be an exclusive agent. With the second company, she would be a direct writer. What changes would Sarah Jane observe if she switched from being an independent agent to operating as an exclusive agent or direct writer?
As an independent agent, Sarah Jane is an independent businessperson representing more than one insurer. She owns the expiration rights to coverage she sells and her renewal commission are equal to the commission earned on new business. As an exclusive agent, Sarah Jane would still be an independent businessperson, however she would represent only one company. The company, rather than Sarah Jane, would own the expiration rights and a higher commission would be paid on new business than on renewal business. If she takes the job as a direct writer, Sarah Jane will be an employee rather than an agent. She will be paid a salary and will represent only one insurer.
Ch.6: Short answer question 6) What are the steps in the claims settlement process?
Before a claim can be settled, the insured must notify the insurance company (or their agent) that a loss has occurred. Upon notification, the insurance company will investigate the claim. Next, the insured must file proof of loss. Finally, the adjustor must make a decision about whether the claim will be paid and if so, the amount of the settlement.
Bruce obtained health insurance coverage from a nonprofit prepayment plan that provides coverage for physicians' and surgeons' fees and hospital service. Bruce obtained this coverage from a:
Blue Cross and Blue Shield Plan
Which of the following statements is true with regard to insurance market dynamics? I. When the property and liability insurance industry is in a strong surplus position, insurers can cut premiums and loosen underwriting standards. II. Insurance companies can lose money on their underwriting activities for the year, but still show a profit for the year.
Both I and II
Which statement is true with regard to insurance company investments? I. Investment income helps to reduce the cost of insurance. II. Pooled premiums of insurance companies are an important source of funds in the economy.
Both I and II
Which statement(s) about mutual insurers is (are) true? I. They are owned by their policy-owners. II. Some mutual insurers are permitted to assess policy-owners of losses are higher than anticipated.
Both I and II
ABC Insurance Company would like to begin offering depository and lending services to its policy-owners. ABC Insurance Company purchased a small credit union, and through the credit union, ABC offers these services to their policy-owners. This scenario illustrates:
Cross-industry consolidation
Cindy sells property and liability insurance. She is a salaried employee of the one company that she represents. Cindy is a(n):
Direct writer
Ch.6: Short answer question 8) What is the distinction between facultative reinsurance and treaty reinsurance?
Facultative reinsurance is an optional, case-by-case, method of reinsurance. The ceding company has no pre-established relationships with a reinsurer. When reinsurance is needed, the ceding company shops for it. With treaty reinsurance, the ceding company and reinsurer have a pre- existing agreement. Any coverage written falling within the scope of the agreement is automatically reinsured.
True/False A captive insurance company is a mutual insurance company that is owned by stock insurance company.
False
True/False A dollar received today is less valuable than a dollar received a year from today.
False
True/False Chief risk officer is another name for risk manager.
False
True/False Demutualization makes it more difficult for an insurer to raise capital.
False
True/False Insurance industry merges have no impact upon the practice of risk management.
False
True/False Lloyd's of London restricts its underwriting to heterogeneous loss exposures, such as a star quarterback's arm or famous dancer's legs.
False
True/False Mass merchandising refers to selling life and health insurance through the mail, newspapers, or other media.
False
True/False Mutual insurance companies may only write life and health insurance/
False
True/False Mutual insurers guarantee dividend payments to their policy-owners.
False
True/False Risk management intranets are designed to provide information to the general public.
False
True/False Stock insurance companies frequently issue assessable insurance policies.
False
True/False The managerial system is a distribution system for property and liability insurance.
False
True/False Company adjustors are independent contractors who insurance companies hire on an as-needed basis.
False
True/False Employment opportunities in the insurance industry are narrow and limited.
False
True/False Insurance companies do not use information systems.
False
True/False Property and liability insurance company investments tend to be of longer duration than do life insurance company investments.
False
True/False The individuals who determine the rate to charge for insurance coverage are called "producers"
False
True/False it is impossible for a property and liability insurance company to grow too fast.
False
Ture/ False A combined ratio greater than one (or one hundred percent) indicates profitable underwriting.
False
Ch.4: Short answer question 1) What is financial risk management? What types of risk are considered in financial risk management?
Financial risk management is the identification, analysis, and treatment of the speculative financial risks the organization faces. Such risks include commodity rice risk, interest rate risk, and currency exchange rate risk. These risks differ from the traditional risks addressed by risk managers in that for these risks, there is also the possibility of a gain.
Traditional risk management addressed all of the following loss exposures EXCEPT:
Financial risks
All of the following channels are used to distribute property and liability insurance EXCEPT:
General agency system
Which statements is true with regard to insurance ratemaking? I. Rates are calculated by people known as adjustors. II. An insurer doesn't know when the insurance is sold if the premium charged is adequate.
II only
Ch.5: Case Applications Case #2: Benson Insurance gives an award each year or two sells the most insurance coverage. In three of the last five years, this award was won by Clark Edwards. In an effort to determine what makes Clark such a successful agent, Benson Insurance Company decided to examine the business he produce. In the examination, the company learned that insureds solicited by Clark had 50 percent more claims than business solicited by others Benson Insurance agents. Benson Insurance is rethinking how the company compensates and rewards his agents. How might compensation and rewards be restructured to obtain better underwriting results?
If Clark is being compensated on a straight commission basis, he has an incentive to sell as much insurance coverage as possible. To do this, he may be soliciting bad risk, and some of these bad risk may be slipping past the company's underwriting and producing an above-average number of claims. Rather than only considering the quantity of coverage sold, Benson Insurance could also consider the quality of the applicants solicited by its agents. Benson Insurance could, for example, consider the ratio of losses paid to premiums dollars written by the agent (profit-sharing commissions). The annual award could be changed from an award based on quantity only to an award recognizing quantity and quality of coverage sold.
Ch.5 Short answer question 7) If a business needs a specific type of insurance, and none of the insurers licensed to operate in its state market that type of insurance, how can the business obtain the coverage?
In this situation, the business would obtain coverage through a non-admitted insurer. As such an insurer has not been admitted to operate in the state, the insurer will not have sales representatives in the state. To obtain coverage with a non-admitted insurer, a specialist known as a SURPLUS LINES BROKER may be used. Surplus lines brokers are authorized to place coverage with non-admitted insurers.
All of the following methods are used to distribute life insurance EXCEPT:
Independent agency system
Ch.6: Short answer question 9) Why are investment important to insurance companies?
Insurance companies have two major sources of income. First, insurers have the insurance products the market. This portion of the business is called the underwriting side of the ledger. Premium income may or may not be sufficient to pay losses and cover expenses. Second, insurers have an opportunity to make money though investments. As premiums are paid in advance, insurance companies an invest these funds and generate investment income. Investment income helps to hold premiums lower and offset any losses the insurer may sustain on the underwriting side of the ledger.
Second National Bank agreed to pay a high rate of return on long-term certificates of deposit. Shortly after several depositors opted for the long term CDs, inflation plunged and rates of return dropped. Second National must continue to pay high rates on long-term CDs even though interest rates have declined significantly. This scenario illustrates:
Interest rate risk
Ch.5 Short answer question 5) What are the distinctive characteristics of Lloyd's of London?
Lloyd's of London has several distinctive characteristics. First, Lloyd's of London is technically not an insurance company but rather an association providing service to its members. Second, the insurance coverage is written through syndicated that belong to Lloyd's of London. third, new "names" have limited liability with respect to the insurance they write as individuals. Fourth, corporations with limited liability can also join Lloyd's of London. Fifth, individual members must meet stringent financial requirements. Finally, Lloyd's of London is licensed only in a small number of jurisdictions in the United States.
Which of the following are you LEAST LIKELY to observe when the property and liability insurance market is "HARD"?
Low premiums
A plan for providing property and liability insurance to individuals in a group under a single program of insurance at reduced rates is called:
Mass merchandising
Ch.5 Short answer question 10) What are the characteristics of mass merchandising?
Mass merchandising has a number of distinctive characteristics. First, property and liability insurance is sold to individual members of a group. Second, individual underwriting is employed. Third, rates are lower because of lower commissions and lower administrative expenses. Finally, employees usually found all of the coverage without contributions from employers.
Because demutualization is a slow and cumbersome process, some states have enacted legislation that allows mutual company to be reorganized so that it may own or acquire control of stock companies that can issue additional shares of common stock. The reorganized mutual company is called a (n):
Mutual holding company
A risk manager was considering a range of possible losses that her company might experience next year. She noted that major production facilities could only be destroyed once during the year, because the destruction of the production facility by one peril means that the facility could not be destroyed a second time. What is the situation called where the occurrence of one event precludes the occurrence of a second event?
Mutually exclusive events
Which of the following statements is (are) true with respect to the time value money? I. One dollar received today is worth less than one dollar to be received three years from today. II. The time value of money should be ignored in capital budgeting decisions.
Neither I nor II
Which statement is true with regard to independent insurance agents? I. They are compensated through a salary paid by the insurers they represent II. They represent only one insurer.
Neither I nor II
A risk manager was attempting to estimate how much many physical damage claims would be reported for vehicles in the company's fleet the following year. He decided to perform a regression analysis using "number of vehicle claims" as the dependent variable. It would make sense to use each of the following variables as the independent variable EXCEPT:
Number of people employed by the company
Which statement is true with regard to agents and brokers? I. Life insurance agents typically have greater authority to bind coverage than do property and liability insurance agents. II. Brokers legally represent insurance purchases, not insurers.
Only II
Kevin's background is market research. He was hired by Alpha Insurance to perform an analysis of consumers in a certain geographic region. His research indicated that although these consumers were fairly affluent, most did not have large amounts of life insurance. Kevin's position at the insurance company would fall under which functional area?
Production
Ch.6: Short answer question 4) In the context of insurance, what is meant by the term "production"?
Production refers to the sales and marketing activities of insurers. Agents who sell coverage are known as "producers". In addition to agents who are visible in the field, there is a production, department at the insurer's home or regional office.
Integrity Insurance entered into a reinsurance agreement with Omega Reinsurance. Under terms of the agreement, Omega receives 40 percent of the premiums and is responsible for 40 percent of the losses, regardless of the size of the policy written by Integrity. What type of reinsurance is illustrated in this scenario?
Quota-share treaty
What type of insurer can be defined as an unincorporated mutual in which each member insures the other member and, in turn, is insured by the other members?
Reciprocal exchange
All of the following are reasons for using reinsurance EXCEPT:
Reinsurance reduces the number of claims
Ch.6: Short answer question 7) What is reinsurance and why would an insurance company use reinsurance?
Reinsurance refers to the shifting of part or all of the insurance originally written by one insurer to another insurer. The company originally writing the coverage may wish to transfer part or all of the risk to a reinsurer for a number of reasons: to increase underwriting capacity, to stabilize profits, to reduce the unearned premium reserve, and to provide protection against catastrophic loss. Reinsurance also enables an insurance company to retire from line of business or from a territory.
Jenna is the risk manager of LMN Company. Jenna was contacted by a vendor who was selling a computerized database that Jenna could use in LMN's risk management program. The database was capable of storing and analyzing risk management data and generating reports for Jenna. This computerized data base is called a (n):
Risk management information system
As an alternative to reinsurance, some insurers transfer insurable risk to the capital markets through the creation of a financial instrument, such as a catastrophe bond. Such transfers are called:
Securitization of risk
Ch.4: Short answer question 6) What is securitization of risk and how does risk securitization increase the capacity of the insurance industry?
Securitization of risk means that insurable risk is transferred to the capital markets through the issue of a financial security. A catastrophe bond issue by an insurer is a good example. The security pays interest and principal to the lender, just like other corporate bonds. If a catastrophic loss occurs, however, the issuer is not require to make some or all of the scheduled payments to the bondholder. The retained funds can be used to finance catastrophic losses. Through risk securitization, the financial resources of the capital markets can be used to finance catastrophic losses, rather than simply relying on the capacity of insurers and reinsurers.
Some mutual companies have gone through a conversion process and have become stock insurance companies. All of the following are advantages of the stock form of organization relative to the mutual form of organization EXCEPT:
Stock insurance companies are exempt from state premium taxes and federal income taxes.
Ch.5 Short answer question 3) How do stock insurance companies and mutual insurance companies differ?
Stock insurances are owned by theirs stockholders who participate in the profits and losses of the insurer. Stock companies cannot issue assessable policies. Mutual companies are owned by their costumers, the policy-owners. If the experience of the mutual insurer is favorable, the company may refund a portion of the premiums paid to the policy-owners through dividend payments.
John would like to start a business raising race horses. When he inquired about insurance coverage for race horses, he learned that none of the insurers operating on his state sell that particular type of coverage. In his state, insurance on race horses would be described as a(n):
Surplus line
Ch.4: Short answer question 8) What is meant by the phrase "time value money"? Why is it important to apply time value of money analysis in risk management decision making?
The "time value money" means that when cash flows are examined, it is important to consider the interest-earning capacity of money. The value of $1000 to be received today is $1000. The value of $1000 to be received one year from today is less than $1000. Because, If you had $1000 today, you could invest the money and earn interest. One year from today your $1000 would be worth more than $1000. So in valuing cash flows, it is important to consider the timing of the cash flows. The same amount of money is different time periods is of different values once the interest-earning capacity of the money is considered.
Ch.6: Short answer question 5) What are the insurers's basic objectives in settling claims?
The basic objective of an insurer in settling claims include: verification that the loss occurred and was covered under the terms of the insurance contract, fair and prompt payment of covered claims, and personal assistance to insureds.
Ch.5 Short answer question 8) What are the primary methods of marketing life insurance coverage?
The primary methods of marketing life insurance coverage includes: the agency building system (which includes general agency system and managerial system), the non-building agency system, and the direct response system.
Ch.5 Short answer question 9) What are the primary methods of marketing property and liability insurance coverage?
The primary methods of marketing property and liability insurance coverage include: independent agency system, the exclusive agency system, through direct writers, the direct response system, and through multiple distribution system.
Ch.5 Short answer question 1) List three types of mutual insurers.
The types of mutual insurers include: assessment mutuals advance premiums mutuals, and fraternal insurers.
Ch.4: Short answer question 3) What is the underwriting cycle? Be sure to discuss a "hard insurance market" and a "soft insurance market" in your answer.
The underwriting cycle is an interesting phenomenon in property and liability insurance markets. Premiums levels, underwriting stringency, and underwriting results exhibit a cyclical pattern over time. In a " hard insurance market" premiums are high and underwriting standards are tight. Business written during this time is usually profitable, helping the industry to build/restore surplus. When the industry is in a strong surplus position, a natural consequences is price competition and a "soft insurance market". In a soft market, insurers compete by lowering prices and loosening underwriting standards. This business is often unprofitable, and the insurer must drawn upon the surplus to fund the losses. As a surplus is eroded, rate hikes and a return to tighter underwriting standards are warranted. Surplus is restored, and the cycle repeats itself.
Ch.4: Short answer question 5) What three types of insurance industry consolidation impact risk management?
There are three types of consolidations that impact risk management. First, there are managers between insurers. Second, there are managers of insurance brokerages. Finally, there are cross-industry consolidations. The last category includes mergers and acquisitions between banks, insurers, brokerages, and other financial institutions.
Insurance companies need a legal department for all of the following reasons EXCEPT:
To prepare the insurance company's financial statements
Ch.4: Short answer question 2) How does enterprise risk management differ from traditional risk management and financial risk management?
Traditional risk management addresses property, liability, and personnel risks only. Financial risk management addresses speculative financial risks. Enterprise risk management is broad concept that encompasses traditional pure risks and speculative financial risks. In addition, enterprise risk management addresses the organization's strategic and operational risks- all the risks faced by the organization.
True/False A strong surplus position means that an insurance company is well-positioned to write coverage and take on risk.
True
True/False An independent agent, rather than the company he or she represents, owns expirations right to the coverage the independent agent has sold.
True
True/False Blue Cross/Blue Shield organizations stress service benefits rather than cash benefits.
True
True/False Catastrophe modeling can be employed by insurers, brokers, ratings agencies, and companies, that have exposure to catastrophic loss.
True
True/False Contractual provision and capital market instruments can be used to address financial risks.
True
True/False Exclusive agents represent only one insurer or a group of insurers under common ownership.
True
True/False Fraternal insurance companies are one type of mutual insurer.
True
True/False If two events are dependent, the occurrence of one event affects the occurrence of the second event.
True
True/False Surplus lines brokers are authorized to place coverage with non-admitted insurers.
True
True/False The goal of regression analysis is to use the past relationship between variables to assist in predicting future results.
True
True/False Time value of money analysis should be applied in capital budgeting decisions.
True
True/False personal-producing general agents are hired to sell insurance and not to recruit new agents.
True
True/False Catastrophe bonds are issued by insurance companies to help fund catastrophic losses.
True
True/False Enterprise management includes consideration of speculative financial risks.
True
True/False If an insurance company is using facultative reinsurance, it must look for a reinsurer each time the company uses reinsurance.
True
True/False Insurance companies may limit the amount of coverage they are willing to write on a certain exposures.
True
True/False One goal of underwriters is to prevent adverse selection from occurring.
True
True/False Reinsurance can be used to provide protection against catastrophic loss.
True
True/False Underwriters select and classify insurance applicants.
True
True/False With surplus-share treaty reinsurance, the proportions of premiums and losses shared by the ceding company and the reinsurer depend on the amount of coverage written.
True
Ch.6: Short answer question 2) Why is the role of underwriters in the insurance industry?
Underwriters are charged with selecting and classifying the applicants for insurance. Just because an agent forwards an application to a home office or a regional office does not mean that the coverage will be written. The underwriter may reject the applicant. If the applicant is acceptable, the underwriter must assign the applicant to the appropriate rating category. The classification of acceptable risks is designed to assure equity in the rating classes. Thus, riskier must pay more for their coverage than insureds who are less risky.
Ch.6: Short answer question 3) Where do underwriters obtain the information they need to make their decision?
Underwriters obtain information from variety of sources, including: the application, the agent's report, an inspection report, physical inspection, physical exams and physicians's report, and the medical information bureau (MIB.
Individuals who have higher-than-average probability of experiencing a loss often try to pass as average risks in order to obtain insurance at more favorable rates. What functional area at insurance companies attempts to detect such individuals?
Underwriting
Ch.6: Case Applications Case #1: When Betty, an underwriter, returned from lunch one day, she discovered a sign had been placed on her desk. The signed featured the word "SALES" in large black letters, with a red circle drawn around the word and a line drawn through it. Another underwriter told Betty that Alan, an agent, placed the sign on her desk. Why would Alan leave this sign on Betty's desk? Hint- What are the functions of producers and underwriters, and how are producers compensated?
While it is the job of agents to solicit applicants for coverage, it is the job for underwriters to determine if the applicants are insurable and, if so, at what rate. Many insurance agents are compensated through commissions, and commissions are only earned when coverage is actually sold. Based on the description provided, it is likely that Alan has submitted a number of applications that Betty either rejected or classified as "riskier than average". Perhaps the "risker than average" applicants sought insurance coverage with another company. Alan is displeased with Betty's underwriting decisions. He is trying to earn commission while she is finding deficiencies with the applicants that he brings forward.
Ch.4: Case Application Case 1: Universal Megatronics is a conglomerate comprised of three large divisions: HMR Bank and Mortgage Lending, International Construction Company, and The Cotton Apparel Company. When the three companies merged the management team decided to centralized risk management. Ken Campbell, who was the risk manager of the construction company, was named risk manager of Universal Megatronics. he has been asked to expand the traditional role of risk management to consider financial risk. Identify the types of financial risk inherent in each division and discuss how risk could be addressed: a) HMR Bank and Mortgage Lending is in very competitive business. Savers demand a competitive return on savings, while mortgage borrowers want the lowest rate possible. The majority of HMR mortgages are 30-year and 15-year fixed-rate loans. b) U.S.-based International Construction Company engages in large projects in Europe and the Pacific Rim. Contracts are negotiated in advance, and all payments are made with local currency. International Construction requires payment of one-third pf the cost of the project when construction begins, one-third when construction reaches the halfway point, and one-third upon completion of the project. some projects require up to three years to complete. c) Cotton Apparel Company has contracts to deliver clothing to two national store chains. Buyers from the store order apparel in desired styles and quantities with delivery expected 6 to 9 months after the orders are placed. Cotton Apparel purchases "raw" cotton and converts it to fabric needed for the clothing its mills produce.
a) HMR Bank and Mortgage Lending presents the classic interest rate problem. Borrowers have borrowed money at fixed rates for long periods ( 30 and 15 years). If short-term rates increase significantly, the company will have a significant portion of its loan portfolio earning a lower rate of interest. One solution may be greater use of variable interest rate loans so the interest rate fluctuations over time with current market rates. Incentives could be offered for borrowers to accept variable rates loans. Another possibility is to "swap" the fixed-rate loans with another financial institution that has too much exposure to variable loan rate loans. b) International Construction Company's payments terms present an interesting currency exchange rate risk problem. The company receives one-third of cost pt-front, and there is the risk that currency paid al later stages of construction may have lost value. The risk manager could try to get more of the money up-front, or use currency futures to hedge this exchange rate risk. c) The financial risk with Cotton Apparel Company is a commodity price risk. The company enters into agreements to deliver clothing at an agreed-upon price today, with delivery in the future. In the meantime, something might happen that would cause the price of cotton to increase significantly, altering the profitability of the transaction. The risk could be hedged through cotton futures contracts.
Ch.6: Case Applications Case #2: Although each of the insurance company operations was discussed separately in this chapter, there is interaction between and among these functional areas. For each of the pairs of functional areas listed below, explain why there might be a need for interaction between the areas. a) ratemaking and production b) claims and underwriting
a) Ratemaking may have a direct impact upon production. For example, if the rate-makers determine a rate for a product that is not competitive with other insurers, it will be difficult for the company's agents to sell the coverage. Agents may also provide input to help price a risk, especially in commercial insurance. b) The claims personnel adjust losses- they see the types pf losses that occur and the extent of the damage. An underwriter may have difficulty evaluating an insurance application because he or she may not be aware of thew types of losses that could occur or the potential severity of these losses. The underwriter might call upon someone from the claims area to assist in evaluating loss exposures.
Ch.4: Case Application Case 2: Carla Powell is the risk manager of LMN Industries. Several questions have arisen and she has asked for your assistance: a) A loss control investment will cost $30,000 today. The project will generate three cash flows: $10,000 one year from today, $20,000 two years from today, and $10,000 three years from today. What is the project's net present value (NVP) if the proper discount (interest) rate is 8 percent? b)The probability that a fire will damage an LMN production facility (Location #1) is 4 percent in any given year. The annual probability that a wind storm will damage the same production facility is 6 percent. LMN has another production facility (Location #2) located 800 miles from the first facility. The probability that a fire will damage the second facility in any year is 5 percent. The annual probability that the second facility will experience a flood loss is 2 percent. 1)What is the probability that Location#1 will have BOTH a file loss and a wind loss in the same year? 2)What is the probability that Location #2 will have at LEAST one flood loss or fire loss in a given year?
a) The NPV is equal to the sum of the present value of the future cash flows less the cost of the project: 10,000/(1+.08) + 20,000/(1+.08)^2 + 10,000/(1+.08)^3 - 30,000 = NPV 9,259 + 17,147 + 7,938 - 30,000= $4,344 The NPV is $4,344. And the NPV is positive(+), the project is acceptable. b.1) There is only a slight chance that BOTH of the events will occur, as the probability that either event will occur is small. The probability that BOTH events will occur is the product of the individual probabilities: 0.04 x 0.06 = 0.0024 or .24% b.2) As the events are not mutually exclusive (BOTH COULD OCCUR), the probability that at least one will occur is the probability that either will occur minus the probability that both will occur: 0.05 + 0.02 - (0.05 x 0.02) = 0.069 or 6.9%
All of the following are usual sources of information for an underwriter EXCEPT:
taped phone conversations
