FIN 401 Review questions CH 1

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

A direct loss is a financial loss that results from the physical damage, destruction, or theft of property. Indirect loss results from or is the consequence of a direct loss. For example, if a student's car is stolen (direct loss), he or she will lose the use of the car until it is replaced or recovered (indirect loss).

What is a loss exposure?

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

Define chance of loss

Chance of loss can be defined as the probability that an event will occur

How does diversifiable risk differ from nondiversifiable risk?

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

Explain the meaning of enterprise risk

Enterprise risk is a term that encompasses all major risks faced by a business firm, which include pure risk, speculative risk, strategic risk, operational risk, and financial risk.

What is enterprise risk management?

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

What is financial risk?

Financial risk is the uncertainty of loss because of adverse changes in commodity prices, interest rates, foreign exchange rates, and the value of money

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

What is the difference between objective probability and subjective probability?

Objective probability refers to the long-run relative frequency of an event based on the assumption of an infinite number of observations and no change in the underlying conditions. Subjective probability is the individual's personal estimate of the chance of loss.

How does objective risk differ from subjective risk?

Objective risk is the relative variation of actual loss from expected loss. As the number of exposure units under observation increases, objective risk declines. Subjective risk is uncertainty based on one's mental condition or state of mind. Accordingly, objective risk is measurable and statistical; subjective risk is personal and not easily measured.

What is the difference between peril and hazard?

Peril is the cause of loss. Hazard is a condition that creates or increases the chance of loss

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

Personal risks associated with great financial and economic insecurity include the risks of premature death, insufficient income during retirement, old age, poor health, unemployment, and alcohol and drug addiction. In addition, persons owning property are exposed to the risk of having their property damaged or lost from numerous perils. Finally, liability risks are also associated with great financial and economic insecurity.

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

Physical hazard is a physical condition that increases the chance of loss. Moral hazard is dishonesty or character defects in an individual that increase the chance of loss. Attitudinal hazard (morale hazard) is carelessness or indifference to a loss. Legal hazard refers to characteristics of the legal system or regulatory environment that increase the frequency or severity of losses.

Explain the difference between pure risk and speculative risk.

Pure risk is defined as a situation in which there are only the possibilities of loss or no loss. Speculative risk is defined as a situation where either profit or loss is possible.

Briefly explain each of the following risk-control techniques for managing risk: Avoidance Loss prevention Loss reduction Duplication Separation Diversification

Risk control techniques refer to techniques that reduce the frequency or severity of losses. They include the following: (1) Avoidance. This means a certain loss exposure is never acquired, or an existing loss exposure is abandoned. For example, a drug manufacturer can avoid lawsuits associated with a dangerous drug by not producing the drug. (2) Loss prevention. Certain activities are undertaken that reduce the frequency of a particular loss. One example of loss prevention is periodic inspection of steam boilers to prevent an explosion. (3) Loss reduction. This refers to measures that reduce the severity of a loss after it occurs. One example of loss reduction is an automatic sprinkler system in a department store that can reduce the severity of a fire loss. (4) Duplication. This technique refers to have back-up or duplicate copies of important documents or property in the event a loss occurs. (5) Separation. The assets exposed to loss are separated or divided to minimize the financial loss from a single event. (6) Diversification. This technique reduces the chance of loss by spreading the loss exposure across different parties.

Briefly explain each of the following risk-financing techniques for managing risk: Retention Noninsurance transfers Insurance

Risk financing refers to techniques that provide for the payment of losses after they occur. They include the following (1) Retention. This means that an individual or business firm retains part or all of the losses that can result from a given loss exposure. For example, a motorist may retain the first $500 of a physical damage loss to his or her automobile by purchasing an auto insurance collision policy with a $500 deductible. (2) Noninsurance transfers. This means that a risk is transferred to another party other than an insurance company. For example, the risk of a defective television set can be shifted or transferred to the retailer by the purchase of a service contract by which the retailer is responsible for all repairs after the warranty expires. (3) Insurance. Insurance transfers risk to an insurer that pays if a loss occurs. An auto insurance policy can be purchased covering liability arising from the negligent operation of an automobile.

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

Risk is a burden to society in at least three ways: (a) The size of an emergency fund must be increased. (b) Society may be deprived of needed goods and services. (c) Worry and fear are present.

What is systemic risk?

Systemic risk is the risk of collapse of an entire system or entire market due to the failure of a single entity or group of entities that can result in the breakdown of the entire financial system.

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.

How does enterprise risk management differ from traditional risk management?

Traditional risk management considered only major and minor pure risks faced by a corporation. These risks were limited to property, liability, and personnel-related loss exposures. Enterprise risk management considers all risks faced by a corporation