Chapter 2~Objective of Risk management

*Correct*? a. The fundamental objective of risk management is to maximize the cost of risk. b. Minimizing the cost of risk implies that risk itself is also minimized. c. In general, we can say that the cost of achieving zero risk for firms is not too high. d. The cost of testing the product for safety is an important component of the cost of risk for a pharmaceutical company which is developing a new prescription drug for the treatment of cancer

. The cost of testing the product for safety is an important component of the cost of risk for a pharmaceutical company which is developing a new prescription drug for the treatment of cancer

If a person facing two risky alternatives, whose expected outcomes are the same, chooses the alternative with less variability, this person is:

. risk adverse or risk averse.

If an individual is "risk averse," then which of the following risky alternatives she may consider?

50% chance of winning $10 and a 50 percent chance of losing $10

(TRUE or FALSE?) Cost of loss control could be due to (1) retention and self-insurance, (2) buying insurance, (3) applying hedging tools, (4) arranging other risk transfers.

F

(TRUE or FALSE?) If the probability of worker injury is 10%, and the health care of injured worker, when it happens, is approximately $60,000, then the expected loss, E(L), is $12,000.

F

(TRUE or FALSE?) In the case of worker injuries, the safety expenditures are not a part of the cost of loss control activities.

F

(TRUE or FALSE?) In the context of business risk management, minimizing firm value is equivalent to minimizing the cost of risk.

F

(TRUE or FALSE?) Risk lowers costs on businesses and individuals.

F

(TRUE or FALSE?) The cost of loss control for potential fire damage to a firm's warehouses should include the cost of installing sprinklers.

F

(TRUE or FALSE?) The cost of product liability insurance is not a component of the cost of risk for a pharmaceutical company which is developing a new prescription drug for the treatment of cancer.

F

(TRUE or FALSE?) The cost of risk is just equal to the cost of loss control plus the cost of internal risk reduction.

F

(TRUE or FALSE?) The cost of testing the product for safety is not a component of the cost of risk for a pharmaceutical company which is developing a new prescription drug for the treatment of cancer.

F

(TRUE or FALSE?) The total cost of risk includes the cost of raw materials.

F

*Incorrect*? . All the answers are correct. b. Firm value depends on the magnitude, timing, and riskiness of the net income. c. Cost of risk = Firm value without risk - Firm value with risk. d. The cost of risk is equal to the value of the firm without risk minus the value of the firm with risk. e. Risk imposes costs on businesses and individuals.

Firm value depends on the magnitude, timing, and riskiness of the net income.

*Incorrect*? a. If a workplace is riskier, then the workers may demand lower salaries to work there. b. The fundamental objective of risk management is to minimize the cost of risk. c. All the answers are correct. d. Cost of internal risk reduction could be due to diversification efforts and investing in information at workplace. e. The cost of loss control for potential fire damage to a firm's warehouses would include the cost of damage to goods in the building.

If a workplace is riskier, then the workers may demand lower salaries to work there.

*Incorrect*? a. Cost of internal risk reduction could be due to diversification efforts and investing in information at workplace. b. The total cost of risk includes the cost of insurance. c. In a real world situation, eliminating the risk of loss would be easy for businesses and consumers alike. d. All the answers are correct. e. The cost of marketing the product to doctors should not be a part of the cost of risk for a pharmaceutical company which is developing a new prescription drug for the treatment of cancer.

In a real world situation, eliminating the risk of loss would be easy for businesses and consumers alike.

*Incorrect*? a. If the probability of worker injury is 10%, and the health care of injured worker, when it happens, is approximately $60,000, then the expected loss, E(L), is $6,000. b. All the answers are correct. c. In the case of worker injuries, the expected losses does not include the expected lost productivity. d. Residual uncertainty can affect the amount of compensation that investors require to hold a firm's common stock. e. Greater safety regulation may lower expected losses but also increases loss control costs.

In the case of worker injuries, the expected losses does not include the expected lost productivity.

Which of the following factors helps to explain why managers of large firms have an incentive to maximize shareholder value?

Managers are often compensated with bonuses linked to the firm's profitability or stock price.

*Correct*? a. "In the context of agency problem, monitoring by shareholders with large stakes does not motivate managers to maximize shareholder value. b. The total cost of risk does not include the cost of investments in information to reduce risk. c. All the answers are incorrect. d. A firm's efforts to minimize the cost of risk result in the firm's value minimization. e. Minimizing the cost of risk does not imply that the variability of losses is minimized.

Minimizing the cost of risk does not imply that the variability of losses is minimized.

*Incorrect*? a. Risk Management is not costless. For example, risk management through loss control and insurance are costly. b. All the answers are correct. c. In the context of business risk management, maximizing firm value is equivalent to minimizing the cost of risk. d. In the case of worker injuries, the expected losses include the expected employee replacement costs. e. Risk lowers costs on businesses and individuals.

Risk lowers costs on businesses and individuals.

(TRUE or FALSE?) Agency costs reduce business value.

T

(TRUE or FALSE?) Cost of internal risk reduction could be due to diversification efforts and investing in information at workplace.

T

(TRUE or FALSE?) Firm value depends on the magnitude, timing, and riskiness of the expected net cash flows.

T

(TRUE or FALSE?) Firm value with risk = Firm value without risk - Cost of risk.

T

(TRUE or FALSE?) In an ideal world where there is no risk, the cost of risk is equal to zero.

T

(TRUE or FALSE?) In the case of worker injuries, the expected losses include the expected employee replacement costs.

T

(TRUE or FALSE?) In the context of agency problem, having a legal duty of managers may motivate managers to maximize shareholder value.

T

(TRUE or FALSE?) In the context of business risk management, maximizing firm value is equivalent to minimizing the cost of risk.

T

(TRUE or FALSE?) Minimizing the cost of risk does not imply that risk itself is minimized.

T

(TRUE or FALSE?) The firm value maximization implies minimizing the cost of risk.

T

*Incorrect*? a. All the answers are correct. b. If a workplace is riskier, then the workers may demand higher salaries to work there. c. If the probability of worker injury is 10%, and the health care of injured worker, when it happens, is approximately $60,000, then the expected loss, E(L), is $6,000. d. Cost of external risk reduction could be due to non-diversification efforts and divesting of information at workplace. e. "In the context of agency problem, monitoring by shareholders with large stakes may motivate managers to maximize shareholder value.

The correct answer is: Cost of external risk reduction could be due to non-diversification efforts and divesting of information at workplace.

*Incorrect*? a. The total cost of risk includes the cost of insurance. b. The cost of defending against and settling future liability claims is not a component of the cost of risk for a pharmaceutical company which is developing a new prescription drug for the treatment of cancer. c. The cost of risk is not equal to the value of the firm with risk minus the value of the firm without risk. d. All the answers are correct. e. In the context of agency problem, having a legal duty of managers may motivate managers to maximize shareholder value.

The cost of defending against and settling future liability claims is not a component of the cost of risk for a pharmaceutical company which is developing a new prescription drug for the treatment of cancer.

*Correct*? a. Firm value without risk = Firm value with risk - Cost of risk. b. The cost of marketing the product to doctors should not be a part of the cost of risk for a pharmaceutical company which is developing a new prescription drug for the treatment of cancer. c. Firm value depends on the magnitude, timing, and riskiness of the net income. d. Residual uncertainty cannot affect the amount of compensation that investors require to hold a firm's common stock

The cost of marketing the product to doctors should not be a part of the cost of risk for a pharmaceutical company which is developing a new prescription drug for the treatment of cancer.

*Correct*? a. In the case of worker injuries, the expected losses does not include the expected workers' compensation benefits (medical expenses, lost wages). b. Cost of residual uncertainty may go up if the shareholders expect lower returns or the other stakeholders, such as employees may accept lower salaries. c. The cost of risk is not equal to the value of the firm with risk minus the value of the firm without risk. d. All the answers are incorrect. e. The cost of loss control for potential fire damage to a firm's warehouses would not include the cost of fire insurance.

The cost of risk is not equal to the value of the firm with risk minus the value of the firm without risk.

*Correct*? a. If a workplace is riskier, then the workers may demand lower salaries to work there. b. The cost of marketing the product to doctors should be a part of the cost of risk for a pharmaceutical company which is developing a new prescription drug for the treatment of cancer. c. In general, we can say that the cost of achieving zero risk for firms is not too high. d. The cost of testing the product for safety is an important component of the cost of risk for a pharmaceutical company which is developing a new prescription drug for the treatment of cancer.

The cost of testing the product for safety is an important component of the cost of risk for a pharmaceutical company which is developing a new prescription drug for the treatment of cancer.

*Incorrect*? a. In general, we can say that the cost of achieving zero risk for firms is too high. b. The cost of risk is not just equal to the cost of direct losses that will be incurred by the firm due to the risk. c. All the answers are correct. d. The total cost of risk does not include the cost of insurance. e. The cost of achieving zero risk is too high.

The total cost of risk does not include the cost of insurance.

*Correct*? a. In the context of agency problem, having a legal duty of managers does not motivate managers to maximize shareholder value. b. "In the context of agency problem, monitoring by shareholders with large stakes does not motivate managers to maximize shareholder value. c. The total cost of risk includes the cost of increased precautions to control losses. d. All the answers are incorrect. e. The cost of risk is not equal to the cost of direct losses that will be incurred by the firm due to the risk.

The total cost of risk includes the cost of increased precautions to control losses.

*Correct*? a. All the answers are incorrect. b. Increased workplace safety increases loss control costs but also may increase expected direct losses (worker injury costs). c. In a real world situation, eliminating the risk of loss would be easy for businesses and consumers alike. d. The total cost of risk includes the cost of insurance. e. The total cost of risk does not include the cost of investments in information to reduce risk.

The total cost of risk includes the cost of insurance.

*Correct*? a. Efficiency implies that risky activities are stopped when the marginal costs exceed the marginal benefits. b. Increased workplace safety increases loss control costs but also may increase expected direct losses (worker injury costs). c. All the answers are incorrect. d. Risk Management can be costless. For example, risk management through loss control is costless. e. The cost of marketing the product to doctors should be a part of the cost of risk for a pharmaceutical company which is developing a new prescription drug for the treatment of cancer.

a. Efficiency implies that risky activities are stopped when the marginal costs exceed the marginal benefits.

*Correct*? a. The cost of marketing the product to doctors should not be a part of the cost of risk for a pharmaceutical company which is developing a new prescription drug for the treatment of cancer. b. All the answers are incorrect. c. Minimizing the cost of risk implies that risk itself is also minimized. d. The total cost of risk does not include the cost of investments in information to reduce risk. e. When the firms buy insurance loss financing costs increase but also the expected indirect losses (bankruptcy costs) increases.

a. The cost of marketing the product to doctors should not be a part of the cost of risk for a pharmaceutical company which is developing a new prescription drug for the treatment of cancer.

The costs incurred by shareholders in monitoring managerial behavior are known as:

agency costs.

Residual uncertainty can:

be reduced best by retention or self-insurance

Reducing the probability of loss to zero would be too costly but could be best achieved through:

by risk avoidance

*Incorrect*? a. In the case of worker injuries, the expected losses include the expected workers' compensation benefits (medical expenses, lost wages). b. Lost control reduces the expected cost of losses. c. Cost of external risk reduction could be due to non-diversification efforts and divesting of information at workplace. d. The total cost of risk includes the cost of investments in information to reduce risk.

c. Cost of external risk reduction could be due to non-diversification efforts and divesting of information at workplace.

The cost of risk includes all of the following except:

cost of labor

The cost of risk may include all of the following except:

cost of raw materials.

*Incorrect*? a. If the probability of worker injury is 10%, and the health care of injured worker, when it happens, is approximately $60,000, then the expected loss, E(L), is $6,000. b. The firm value maximization implies minimizing the cost of risk. c. Cost of loss financing could be due to (1) retention and self-insurance, (2) buying insurance, (3) applying hedging tools, (4) arranging other risk transfers. d. If a workplace is riskier, then the workers may demand lower salaries to work there.

d. If a workplace is riskier, then the workers may demand lower salaries to work there.

*Correct*? a. Agency costs increase business value. b. In a real world situation, eliminating the risk of loss would be easy for businesses and consumers alike. c. The total cost of risk does not include the cost of increased precautions to control losses. d. Since managers of large firms are often compensated with bonuses linked to the firm's profitability or stock price, they (managers) have an incentive to maximize shareholder value.

d. Since managers of large firms are often compensated with bonuses linked to the firm's profitability or stock price, they (managers) have an incentive to maximize shareholder value.

The cost of risk is equal to:

d. the value of the firm without risk minus the value of the firm with risk.

Which one of the following activities does not prevent managers of firms to deviate from shareholders' wealth maximization?

ethical standards specified in a firm's ethics code

Which one of the following is not an example of the cost of loss financing?

expected direct losses

Minimizing the cost of risk is the same as:

maximizing the shareholders' wealth

The fundamental objective of risk management is:

minimize the cost of risk

The overall objective of risk management for "for-profit" businesses is:

minimize the cost of risk.

The cost of loss control for potential fire damage to a firm's warehouses would include:

the cost of installing sprinklers.

Components of the cost of risk do not include

the cost of issuing bonds

The cost of self-insurance (retention) includes:

the cost of maintaining reserve funds to pay losses

Cost of risk is:

the difference between firm value without risk and firm value with risk

"Loading" in insurance literature means:

the insurer's administrative costs and provides a reasonable expected return on the insurer's capita

From a societal perspective, the key question is how risky activities and risk management by individuals and businesses can be best arranged:

to minimize the total cost of risk for society