Fin 360 Review/Application Questions Midterm 1

Explain the historical definition of risk

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

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

(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.

Several types of risk are present in the American economy. For each of the following, identify the type of risk that is present. Explain your answer.

(a)This is a nondiversifiable risk because the entire nation can be affected by a terrorist attack. (b)This is a pure risk. The insured rarely profits if his or her house is damaged in a fire. (c)This is pure risk because of the loss of earned income. You usually do not profit if you are totally disabled. (d)This is a speculative risk. Profit or loss is possible. (e)This is a nondiversifieable risk because large numbers of people can lose their homes in a major flood. (f)This is a nondiversifiable risk because large numbers of home buyers will be adversely affected by higher interest rates and higher monthly mortgage payments. From the viewpoint of home builders and realtors, a rise in interest rates is also a financial risk that can slow down the sale of new and used homes. (g)This is a speculative risk because both profit and loss are possible.

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).

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.

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 a loss exposure?

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

How does objective risk differ from subjective risk?

It 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.

Identify the major risks faced by business firms.

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

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.

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.

List the major types of pure risk that are associated with economic insecurity.

Pure risks associated with great financial and economic insecurity include the risks of premature death, insufficient income during retirement, old age, poor health, and unemployment. 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.

How does enterprise risk management differ from traditional risk management?

Traditional risk management considered only major and minor pure risks faced by a corporation. Enterprise risk management considers all risks faced by a corporation.