Chapter 4
27) Millie is risk manager of JKL Company. She is considering an investment in a loss control project. The project will cost $40,000. Assuming a 10 percent discount rate, the present value of the future net cash flows that this project will generate is $60,000. What is the net present value (NPV) of this project?
A) $20,000
1) Which of the following is a financial risk that may be faced by a business organization?
D) currency exchange rate risk
5) Businesses face several operational risks. One operational risk is the risk associated with deviations from the organization's regular practices and procedures. This risk is called
B) process risk.
14) A company has a fleet of 200 vehicles. On average, 50 vehicles per year experience property damage. What is the probability that any vehicle will be damaged in any given year?
C) 25 percent
15) RST Company has production facilities in Salt Lake City and Cleveland. The probability that in any given year a fire will damage the production facility in Salt Lake City is 5 percent. The probability that in any given year a fire will damage the Cleveland production facility is 4 percent. What is the probability that BOTH production facilities will be damaged by fire in any given year?
A) 0.20 percent
23) Which of the following statements is (are) true with respect to the time value of money? I. Money received today is worth more than the same amount of money received in the future. II. The present value of a future amount is greater than the future amount.
A) I only
42) Which statement is (are) true concerning catastrophe models? I. Businesses other than insurance companies use catastrophe models. II. Catastrophe models are able to precisely predict disaster occurrences and loss values.
A) I only
24) Calculating the present value of a future amount is called
B) discounting.
39) Uncertainty pertaining to the organization's goals and objectives and the organization's strengths, weaknesses, opportunities, and threats is called
B) strategic risk.
25) The process of determining which set of investments in plant and equipment to undertake is called
D) capital budgeting.
34) LMN Insurance Company is concerned about its exposure to hurricane losses for property risks it insured on the Gulf Coast. LMN borrowed money from investors by issuing financial securities. LMN promised to repay the money it borrowed with interest if hurricane losses do not exceed a specified level. If hurricane losses exceed the specified level, LMN will repay less than it borrowed and use the extra money to fund hurricane losses. The securities that LMN issued
D) catastrophe bonds.
38) Insurance Brokerage Company uses a computer-based method of estimating the losses its clients will suffer if a severe storm or earthquake occurs. This method of estimating losses is called
D) catastrophe modeling.
7) A comprehensive risk management program that addresses all of an organization's risks, includes hazard risks, financial risks, strategic risks, and operational risks is called a(n)
D) enterprise risk management plan.
43) Which of the following is a financial derivative that derives value from specific insurable losses or from an index of values?
D) insurance option
17) Some events cannot occur together because the occurrence of one event makes the occurrence of the second event impossible. Such events are called
D) mutually exclusive events.
49) ABC Company in considering a loss control investment. The project will cost $100,000. It will generate an after-tax net cash flow of $60,000 one year after investment and an after-tax net cash flow of $60,000 two years after investment. The present value of $1 received one year from today assuming a 6 percent rate is .9434. The present value of $1 received two years from today assuming a 6 percent interest rate is .8900. Assuming a discount rate of 6 percent, what is the net present value (NPV) of this project?
A) $10,004
6) Which statement is (are) true with respect to enterprise risk management programs? I. They address traditional property, liability, and personnel loss exposures. II. They do not address financial risks.
A) I only
9) Which statement is (are) true regarding property and liability insurance market conditions? I. Premiums are high when the insurance market is "hard." II. Underwriting standards are tight when the insurance market is "soft.
A) I only
11) The relative level of surplus in the insurance industry is called the industry's
A) capacity.
4) One category of risk that is considered in an enterprise risk management program is the risk associated with an organization's property, liability, and personnel-related loss exposures. This risk is called
A) hazard risk.
54) A risk manager analyzed fleet accident data to help determine which loss control measures would provide the greatest safety incentives for drivers. Examining data to generate information that will help make more informed decisions is called
A) predictive analytics.
28) A computerized data base that permits risk managers to store and analyze risk management data is called a
A) risk management information system.
46) One operational risk that is considered in an enterprise risk management program is risk that develops due to the use of technology by the organization. This risk is called
A) systems risk.
36) Reasons to adopt an enterprise risk management plan include all of the following EXCEPT
A) to increase earnings volatility.
18) Two buildings are located close together at a production facility. The probability that either of these buildings will experience a fire loss is 4 percent. However, if one building has a fire, the probability that the second building will have a fire is 60 percent. What is the probability that both buildings will have a fire?
B) 2.4 percent
12) Which of the following statements is (are) true regarding investment returns and the underwriting cycle? I. Investment returns have no impact upon the underwriting cycle. II. Investment returns can lengthen the duration of a soft market by offsetting underwriting losses.
B) II only
2) Which of the following statements about the scope of risk management is (are) true? I. Traditionally, risk management was limited in scope to speculative loss exposures. II. In the 1990s, some businesses began to expand the scope of risk management to include financial risks.
B) II only
26) Which of the following statements is (are) true regarding the net present value of a capital investment? I. Net present value does not consider time value of money. II. A positive net present value represents an increase in value to the firm.
B) II only
44) Which of the following statements about enterprise risk management (ERM) is (are) true? I. A goal of ERM is to have risks treated in compartmentalized silos. II. There may be resistance to the implementation of an ERM program.
B) II only
55) West Coast Insurance writes property and liability insurance in California, Oregon, and Washington. These states are all susceptible to earthquakes. To help determine how much reinsurance to purchase, West Coast Insurance hired an organization to use a computer algorithm to estimate what its insured losses would be if a severe earthquake occurred. West Coast Insurance based its purchase of reinsurance on the loss estimates. This scenario illustrates using
B) catastrophe modeling.
31) Terrorists attacked the World Trade Center on September 11, 2001. The attack simultaneously created large losses for life insurers, property insurers, workers compensation insurers, health insurers, and liability insurers. What name is given to an event that simultaneously creates large losses in several lines of insurance?
B) clash loss
52) Organizations are answerable to various regulatory agencies and to their owners. Required filings with regulatory agencies and communications with the owners are considered in an enterprise risk management (ERM) program. The risk associated with regulatory filings and required communications is called
B) governance/compliance risk.
48) Last year, XYZ Insurance Company had a combined ratio of 102.4 and lost $10.2 million on the insurance that it sold. The company, however, was required to pay income taxes. The best explanation for this apparent contradiction is that XYZ offset its underwriting loss with
B) investment income.
13) Jessica is the risk manager of a large technology company. To help better understand the risks that her company faces, Jessica prepared a chart listing all of the risks along with pertinent information about each risk. The chart shows the risk category, who is primarily responsible for the risk, the maximum possible and maximum probable loss, the risk severity score untreated and the risk severity score after risk management measures are applied. The chart Jessica prepared is called a
B) risk register.
33) The transfer of insurable risk to the capital markets through the creation of a financial instrument is called
B) securitization of risk.
32) One category of risks that are considered in an enterprise risk management program is risks that are external to the organization. Such risks include demographic trends, acts of competitors, and industry sector trends. This risk is
B) strategic risk.
35) Hedge Fund Company offers a mutual fund to investors. Fund managers are concerned about fund volatility. They analyzed the fund to determine the worst loss likely to occur in a calendar quarter, assuming a 90 percent level of confidence. The worst probable loss is known as the fund's
B) value at risk.
41) Five Below Zero is a new ski resort in Colorado. Five Below Zero is concerned that an abnormally warm winter will prevent the accumulation of snow needed to have a profitable ski season. Five Below Zero purchased a contract that will pay a lump sum if the daily high temperature exceeds 30 degrees for more than 12 days between January 1st and March 31st. The contract Five Below Zero purchased is called a(n)
B) weather option.
16) RST Company has production facilities in Salt Lake City and Cleveland. The probability that in any given year a fire will damage the production facility in Salt Lake City is 5 percent. The probability that in any given year a fire will damage the Cleveland production facility is 4 percent. What is the probability that AT LEAST ONE of the production facilities will be damaged by fire in any given year?
C) 8.80 percent
45) Enterprise risk management (ERM) programs differ from traditional risk management programs in all of the following ways EXCEPT
C) ERM evaluates risks relative to the internal environment only rather than considering both the internal and external environment.
10) Which of the following statements is true regarding insurance market conditions and underwriting results?
C) Insurance rates are high and underwriting standards are tight when the insurance market is "hard."
19) Which of the following statements is (are) true with regard to probability analysis? I. If two events are independent, the occurrence of one event does not affect the occurrence of the second event. II. If two events are dependent, the occurrence of one event affects the occurrence of the second event.
C) both I and II
30) Which of the following statements is (are) true with regard to the use of technology in risk management programs? I. Risk management Intranets are networks intended for an internal audience. II. Risk management information systems can be used to store and track workers compensation claims data.
C) both I and II
37) Which of the following statements concerning the securitization of risk is (are) true? I. Securitization increases the capacity of the insurance industry. II. Securitization can be used to protect against catastrophic loss.
C) both I and II
47) Which of the following statements is true concerning the successful adoption of an enterprise risk management program? I. The management team must be committed to the success of the ERM program. II. Communication about the ERM program is crucial during the implementation stage.
C) both I and II
3) Mid-States Beef is a commercial feedlot business. Currently, the company has over 10,000 cattle in feedlots. Mid-States is concerned that the price of corn, the grain fed to the cattle, will increase significantly. The risk that the price of corn may increase and harm the profitability of Mid-States Beef's operations is a(n)
C) commodity price risk.
51) When announcing that an enterprise risk management program would be implemented at XYZ Company, the president of the company observed, "We must overcome the silo mentality for the program to be successful." The "silo mentality" refers to
C) focusing narrowly on one area and not viewing risk holistically.
50) All of the following are benefits that may accrue to businesses that adopt an enterprise risk management (ERM) program EXCEPT
C) increased cost of risk.
22) A table showing losses that could occur and the corresponding chance that each loss could occur is called a(n)
C) loss distribution.
53) Risk managers may use a number of tools. One tool is the analysis of data to generate information that will help make better informed decisions. Such analysis is called
C) predictive analytics.
21) A method of characterizing the relationship between two or more variables and then using the characterization to make a prediction is called
C) regression analysis.
56) Palmer Polymers is changing from a traditional risk management program to an enterprise risk management program. As a first step, the risk manager determined all the risks that the organization faces. Next, she created a grid with loss frequency on the x-axis and loss severity on the y-axis. Then she plotted all of the loss exposures based on frequency and severity. The grid and the plotted loss exposures are called a
C) risk map.
20) Jane is risk manager of ABC Manufacturing Company. She is trying to decide whether to self-insure her company's workers compensation exposure or to purchase insurance. Jane would like to use regression analysis to predict the number of workers compensation claims that will occur next year. The number of claims will be the dependent variable in the regression. All of the following would be reasonable independent variables to use EXCEPT
C) total assets.
8) The property and liability insurance industry is characterized by a repetitive pattern of loose underwriting standards with low premiums followed by tight underwriting standards with high premiums. This repetitive pattern is called the
C) underwriting cycle.
40) The total exposure that an organization is willing to accept, given the risk and return trade-off for the portfolio of risk the organization faces, is the organization's
D) risk appetite.
29) A grid charting the potential frequency and severity of losses is called a
D) risk map.
