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diversifiable risk

risk that only affects individuals or small groups and not the entire economy. It is a risk that can be reduced or eliminated by diversification.

noninsurance transfers

a risk financing technique in which one party transfers the potential financial consequences of a particular loss exposure to another party that is not an insurer. For example, contracts, leases, and hold-harmless agreements

avoidance

a risk control technique in which a certain loss exposure is never acquired, or an existing loss exposure is abandoned.

non-diversifiable risk

a risk that affects the entire economy or large numbers of persons or groups within the economy, such as inflation, war, or a business recession. It is a risk that cannot be eliminated or reduced by diversification

speculative risk

a risk where either profit or loss is possible

objective risk

relative variation of actual loss from expected loss, which varies inversely with the square root of the number of cases under observation.

operational risk

results from the firms business operations. For example, a bank that offers online banking services may incur losses if "hackers" break into the bank's computer.

self-insurance

retention program in which the employer self funds or pay as part or all of the losses.

risk financing

risk management techniques that provide for the funding of losses after they occur, such as retention, noninsurance transfers, and commercial insurance.

risk transfer

shifting some or all of the cost of a potental loss to a third party

pooling

spreading of losses incurred by the few over the entire group, so that the process, average loss is substituted for actual loss.

hedging

technique for transferring the risk of unfavorable price fluctuations to a speculator by purchasing and selling options and futures contracts on an organized exchange.

expense loading

the amount needed to pay all expenses, including commissions, general administrative expenses, state premium taxes, acquisition expenses, and an allowance for contingencies and profit

premature death

the death of a family had with outstanding unfulfilled financial obligations, such as dependence to support, children to educate, and a mortgage to pay off.

subjective probability

the individuals personal estimate of the chance of loss. For example, people who buy lottery tickets on their birthday may believe it is their lucky day and overestimate the small chance of winning.

objective probability

the long run relative frequency of an event assuming an infinite number of observations and no change in the underlying conditions

Chance of loss

the probability that an event will occur; it is not the same thing as risk.

underwriting

the selection and classification of applicants for insurance through a clearly stated company policy consistent with company objectives.

adverse selection

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. For example, high risk drivers seeking auto insurance

what is the definition of insurance

there is no single definition of insurance. However a typical insurance plan contains four elements: pooling of losses payment of fortuitous losses risk transfer indemnification

explain the historical definition of risk

there is no single definition of risk. Risk historically has been defined as uncertainty concerning the occurrence of a loss.

personal risks

those risks that directly affect an individual. Most personal risks include the following: premature death insufficient income during retirement poor health unemployment

inland Marine insurance

transportation insurance that provides protection for goods shipped on land, including imports, exports, domestic shipments, instrumentalities of transportation, personal property floater risks, and commercial property floater risks.

Ocean Marine insurance

type of insurance that provides protection for all types of oceangoing vessels and their cargoes as well as legal liability of owners and shippers.

risk

uncertainty concerning the occurrence of a loss

strategic risk

uncertainty regarding the firm's financial goals and objectives; for example, if a firm enters a new line of business, the line may be unprofitable.

fortuitous loss

unforeseen and unexpected and occur as a result of chance.

physical hazard

a physical condition that increases the frequency or severity of loss

morale hazard

(attitudinal loss) carelessness or indifference to a loss

indirect loss

(consequential loss) a financial loss that results in directly from the occurrence of direct physical damage or theft loss. Examples of indirect losses are the loss of the property, loss of profits, loss of rents, and extra expenses.

attitudinal hazard

(morale hazard) carelessness or indifference to loss that increases the frequency or severity of loss.

do rest of chapter 2 summary

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pure risks associated with financial insecurity

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explain the major techniques for managing risk

1. risk control (avoidance, loss prevention, and loss reduction) 2. risk financing (retention, noninsurance transfers, insurance)

show how risk is a burden to society

1. the size of an emergency fund must be increased 2. society is deprived of certain goods and services 3. worry and fear are present

risk entails three major burdens on society:

1. the size of an emergency fund must be increased, 2. society is deprived of needed goals and services 3. worry and fear are present

reinsurance

A form of insurance whereby one insurance company (the reinsurer) in consideration of a premium paid to it, agrees to indemnify another insurance company (the ceding company) for part or all of its liabilities from insurance policies it has issued.

retention

A method of dealing with risk by intentionally or unintentionally keeping a portion of it for the insured's account; the amount of responsibility assumed but not reinsured by the insurance company.

enterprise risk management

A process used by a company to help identify the risks that it faces and to develop responses to those risks that enable the company to be reasonably assured of meeting its goals.

loss prevention

A risk control technique that reduces the frequency of a particular loss.

loss reduction

A risk control technique that reduces the severity of a particular loss.

property insurance

A type of insurance that covers damage to property, such as a home.

property risks

Can lead to a loss of personal or business items such as money, vehicles, and buildings.

hold-harmless clause

Clause written into a contract by which one party agrees to release another party from all legal liability, such as a retailer who agrees to release the manufacturer from legal liability if the product injures someone.

peril v. hazards

Harrell is defined as the cause of loss. Hazard is any condition that creates or increases the chance of loss.

pure risk

I risk where there are only the possibilities of loss or no loss.

objective probability versus subjective probability

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

objective risk versus subjective risk

Objective risk is defined as the relative variation of actual loss from expected loss Subjective risk is defined as uncertainty based on a person's mental condition or state of mind

incorporation

The process of legally declaring a corporate entity as separate from its owners. Incorporation has many advantages for a business and its owners, including: 1) Protects the owner's assets against the company's liabilities 2) Allows for easy transfer of ownership to another party 3) Achieves a lower tax rate than on personal income 4) Receives more lenient tax restrictions on loss carry forwards 5) Can raise capital through the sale of stock

enterprise risk

a term that encompasses all major risks faced by a business firm. Enterprise risk management combines into a single unified treatment program all major risks faced by the firm. Such risks include pure risk, speculative risk, strategic risk, operational risk, and financial risk.

liability insurance

a type of insurance policy that protects either an individual or a business from the risk that they may be held liable for something such as malpractice, injury, or negligence.

loss exposure

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

pure v. speculative risk

appear risk is a risk where there are only the possibilities of loss or no loss. A speculative risk is where either profit or loss is possible.

what sort of risks do business firms face?

business firms face a wide variety of major risks that can financially cripple or bankrupt the firm if a loss occurs. These risks include property risks, liability risks, loss of business income, and other risks.

peril

cause or source of loss

legal hazard

characteristics of the legal system or regulatory environment that increase the frequency or severity of losses

indemnification

compensation to the victim of loss, in whole or in part, by payment, repair, or replacement.

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 indefinite number of exposures.

law of large numbers

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

hazard

condition that creates or increases the chance of loss.

fidelity bonds

cover loss caused by the dishonest or fraudulent acts of employees, such as embezzlement and the theft of money.

subjective risk

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

moral hazard

dishonesty or character defects in an individual that increase the chance of loss.

liability risks

extremely important because there is no maximum upper limit on the amount of loss; a lien can be placed on income and assets to satisfy a legal judgment; and substantial court costs and attorney fees may also be incurred.

casualty insurance

field of insurance that covers whatever is not covered by fire, Marine, and life insurance. Includes auto, liability, burglary and theft, workers compensation, glass, and health insurance.

human life value

for purposes of insurance, the present value of the family's share of the deceased breadwinners future earnings.

waterbeds are

generally not covered homeowners insurance. you need to purchase an additional rider in order for it to be covered

social insurance

government insurance programs with certain characteristics that distinguish them from other government insurance programs. Programs are generally compulsory; specific earmarked taxes fund the programs; benefits are heavily weighted in favor of low income groups; and programs are designed to achieve certain social goals. (for example Social Security)

a direct loss to property

ia financial loss that results from the physical damage, destruction, or theft of the property.

life insurance

insurance paid to named beneficiaries when the insured person dies

liability risks

involve the possibility of being held liable for bodily injury or property damage to someone else

Lloyd's of London

is not an insurer, but is the world's leading insurance market that provides services and physical facilities for its members to write specialized lines of insurance. It is a market where members join together to form syndicates to insure and pool risks. Members include some of the world's major insurance groups and companies listed on the London Stock Exchange, as well as individuals (called Names), and limited partnerships.

types of private insurance

life insurance, health insurance, property and liability insurance, personal line coverages, etc.

objective v. subjective probability

objective risk is the relative variation of actual loss from this expected loss. Subjective risk is uncertainty based on an individual's mental condition or state of mind.

The following types of pure risk can threaten an individual's financial security:

personal risks, property risks, liability risks

physical hazard

physical condition that increases the chance of loss. examples of physical hazards include icy roads that increase the chance of an auto accident, defective wiring that increases the chances of fire, and a defective lock on a door that increases the chance of theft.

four major types of hazards

physical hazard, moral hazard, attitudinal hazard, and legal hazard

insurance

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

commercial lines

property and casualty coverages for business firms, nonprofit organizations, and government agencies

personal lines

property and liability insurance coverages that ensure the home and personal property of individuals and families or provide protection against legal liability.

surety bonds

provide for monetary compensation in the case of failure by bonded persons to perform certain acts, such as failure of the contractor to construct the building on time

legal hazard

refers to characteristics of the legal system or regulatory environment that increase the frequency or severity of losses.

risk control

refers to techniques that reduce the frequency or severity of losses. Major risk control techniques include: avoidance, loss prevention, and loss reduction

financial risk

refers to the uncertainty of loss because of adverse changes in commodity prices, interest rates, foreign exchange rates, and the value of money.


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