Exam Review

Regression analysis assumes that

Regression analysis assumes that the variable being forecast varies predictably with some other variable.

Solvency II aims to achieve consistency for insurers across Europe. Solvency II includes standards for which one of the following areas that was not addressed in Solvency I?

Solvency II includes standards for risk management which was not addressed in Solvency I.

One benefit of risk management to the economy is the reduction of the potential for a major disruption in the functioning of financial markets and the financial system. This risk that is reduced is called

Systemic risk.

In calculating the present value of a stream of equal future payments, which one of the following is true?

In calculating the present value of a stream of equal future payments, it is equal to the sum of the present values of each of the separate payments. .

In the context of identifying loss exposures, hazard analysis is a method

In the context of identifying loss exposures, hazard analysis is a method that identifies conditions that increase the frequency or severity of loss.

Question 53. An investment has an initial cash outflow of $30,000 and a return of $0 at the end of the first year and $40,000 at the end of the second year. The required rate of return is 12 percent. What is the net present value of this investment?

Incorrect. $40,000 x present value of a dollar to be received after two years at 12 percent, or $40,000 x .7972 = $31,888, minus the initial investment of $30,000, or $1,888 .

Which one of the following is a responsibility of internal auditors?

It is the responsibility of internal auditors to validate that internal controls are in place, functioning, and meeting design objectives. .

Which of the following best describes the purpose of financial statements?

It is to communicate information about an organization's financial status.

Question 54. Which one of the following is a major purpose of the statement of cash flows?

It is used to determine an organizations ability to generate positive cash flows, its ability to meet financial obligations, and its need for additional financing. It is also used to determine the reasons for any differences between net income and associated cash receipts and disbursements. .

Which one of the following groups of individuals within an organization is responsible for establishing effective internal controls to monitor risk?

Management is responsible for establishing effective internal controls to monitor risk.

Most general liability insurance policies include coverage for which one of the following?

Most general liability insurance policies include coverage for product liability exposure.

NML Microchip Company adopted the COSO framework and integrated it within the company's risk management process. Two months ago, the company's future revenue stream took an unexpected hit when CBA Microchip Company, a small competitor, introduced its new microchip. CBA's new chip is half the physical size of NML's chip, and can store 10 times the information. Many of NML's customers have canceled orders and purchased the CBA chip. At which part of the COSO framework did NML fail?

NML failed to properly anticipate a competitor's technological innovation, which is event identification.

While there are many causes of net income losses, net income losses are usually associated with

Net income losses are usually associated with property losses

Which one of the following statements is true regarding operational risk?

Operational risk is integrated in every activity of an organization.

Question 10. A risk management professional should ensure that an organizational risk register has which one of the following characteristics?

A risk management professional should ensure that an organizational risk register provides interactive use for risk owners.

Question 55. Which one of the following important pieces of risk management information would be found in the notes to the financial statement?

A summary of loss contingencies will be found in the notes to the financial statement.

Question 60. Alternative Fuel Company (AFC) extracts ethanol from corn and sells the ethanol to petroleum companies to mix with their fuel. AFC needs 100,000 bushels of corn each month to produce the ethanol it has contracted to deliver. AFC hedges the price of the corn it needs from June through November, when growing conditions in the Midwest and crop estimates from the U.S. Department of Agriculture (USDA) can lead to wider fluctuations in the price of corn. For the corn needed in six months to fulfill the November delivery, APC spent $18,600 on call options for 100,000 bushels of corn at $5.50 per bushel. In late September, the USDA announced that the corn crop would be much larger than expected, and the price of corn fell to $5.00 per bushel. APC purchased the 100,000 bushels of corn it needed to process the ethanol for the November delivery at $5.00 per bushel. What was AFC's total expenditure (hedging and grain purchase) on the corn needed to fill the November order?

$518,600 The company spent $500,000 on corn and $18,600 on the call options. .

Janet purchased a tract of land in the Florida panhandle 10 years ago and earned an average rate of return on her investment of 7 percent. Today, Janet sold the land for $1,250,000 and must pay capital gains tax on the gain in excess of her original investment. Given this information, how much has her original investment gained in value over the last 10 years?

$614,625 Correct. PV = FVn × PV factor; PV = $1,250,000 × .5083; PV = $635,375; $1,250,000 − $635,375 = $614,625. Her original investment gained $614,625 in value over the last 10 years.

Soy Products Company (SPC) makes a no-fat cheese substitute using soy beans. SPC signed a contract to deliver 100,000 pounds of soy cheese to a chain of health food stores in six months. The health food stores will pay SPC $2.50 per pound of cheese. SPC believes it will need 5,000 bushels of soy beans to produce the cheese. While soy beans currently sell for $10 per bushel, SPC will not purchase the soy beans it needs until three months before delivery of the product. SPC purchased a call option that will allow the company to purchase 5,000 bushels of soy beans at $10 per bushel three months before delivery. Three months before delivery, the price of soybeans had increased to $12 per bushel. Ignoring the cost of the option, how much in production costs did SPC save by hedging the price of the soy beans it needed to fulfill its contract?

$10,000 Correct. Not hedged, SPC would have had to pay $12 per bushel, but because it was hedged, it effectively paid $10 per bushel; a savings of $2 per bushel on 5,000 bushels.

Question 63. Pacific Fuel Company stores refined gasoline in a large underground storage tank, which is encased in a second tank, called a "double hull." Pacific Fuel's risk manager, Merrill, is concerned that fuel could leak from the tank and pollute the ground. To analyze this risk, he constructed an event tree. He believes there is a 40 percent probability that there will be a leak in the tank in the next five years and, if a leak occurs, he believes there is an 80 percent probability that the second hull will contain the leak. If the second hull does not contain the leak, he believes that there is a 70 percent chance of severe pollution and a 30 percent chance of minor pollution. What is the probability of severe pollution from the tank occurring in the next five years?

.40 x .20 x .70 = 5.60 percent; There is a 5.6 percent probability of severe pollution from the tank occurring in the next five years. .

Garnett owns a commercial building and has a lease with a tenant which calls for rental payments to increase annually. To evaluate the lease, she wants to determine the present value of the building's income and then compare that to her costs. The first year's rent is set at $10,000, the second year is $15,000, third year is $20,000, and the 4th year is $25,000. Payments are made on the first day of each year. Assuming a 5 percent interest rate, the present value of the rental income as of the date of the first payment is

10,000 + (15,000 × .9524) + (20,000 × .9070) + (25,000 × .8638) = $64,021; The present value of the rental income as of the date of the first payment is $64,021. .

The management team at Balsam Manufacturing is considering installing spray painting equipment in a currently unused building at the company's premises. The initial investment would cost $160,000 and the equipment would have a useful life of eight years. The expected differential cash revenues resulting from the purchase would be $50,000 annually. The company's risk manager has analyzed the differential probability of a fire resulting from the spray painting operation and has calculated an annual expected loss of $20,000. The following facts apply: •The minimum rate of return that Balsam's management team will accept is 10 percent. •The present value of an annuity of $1 per year for eight years is 5.3349. •The income tax rate is 40 percent. The net present value for the proposed spray painting equipment investment is

50,000 - 20,000 - 4,000 taxes = 26,000; 26,000 X 5.3349 = 138,707; 138,707 - 160,000 = (21,293); If the company installs the spray painting equipment without implementing risk control techniques, the net present value for the proposed investment is ($21,293).

Question 62. Crawford Construction Company is considering the purchase of a new earthmoving machine. The machine will cost $120,000. It will be depreciated on a straight-line basis over its six-year life. The machine will have no salvage value. If the machine is purchased, it is estimated that cash revenues will increase by $70,000 per year for the six years the machine is used. Non-depreciation cash expenses will increase by $15,000 per year in each of the six years. Crawford Construction pays taxes at a rate of 30 percent. What annual, after-tax net cash flow is this project expected to generate?

70,000 - 15,000 - 10,500 taxes = 44,500; This project is expected to generate $44,500.

Lerner Company is considering investment in a drill press machine that will cost $90,000. The machine will have a three year life and will be depreciated on a straight-line basis. There will be no salvage value after three years. The machine will increase cash revenues by $80,000 per year in each of the three years. Cash (nondepreciation) expenses will increase by $20,000 in Year 1, $30,000 in Year 2, and $40,000 in Year 3. Lerner pays taxes at a rate of 30 percent. What after-tax net cash flow does this project generate in Year 2?

80,000 - 30,000 - 6,000 taxes = 44,000; The after-tax net cash flow that this project generates in Year 2 is $44,000. .

A conscious act or decision not to act that generates the funds to pay for losses or offset the variability in cash flows that may occur best defines

A conscious act or decision not to act that generates the funds to pay for losses or offset the variability in cash flows that may occur best defines risk financing.

A financial transaction in which one asset is held to offset the risk associated with another asset it called

A financial transaction in which one asset is held to offset the risk associated with another asset it called hedging.

Aligning risks with the organization's risk appetite defines

Aligning risks with the organization's risk appetite defines tolerable uncertainty.

Jordan is risk manager of Burroughs Mills, a textiles and clothing company. Jordan just renewed the company's property insurance. The insurance that Jordan purchased on the company's warehouse covers all losses except those losses that are excluded. If a loss occurs, the insurer will take depreciation into consideration when determining the loss settlement. Which one of the following descriptions applies to the property insurance that Jordan purchased?

All-risk coverage covers all losses except those excluded; actual cash value coverage considers depreciation in loss settlement.

Which one of the following is an advantage of being a company common stockholder over a preferred stockholder?

An advantage of being a company common stockholder over a preferred stockholder is that common stockholders exercise control over management.

Which one of the following is a benefit to the organization from greater risk assurance?

As there is greater certainty, capital suppliers (lenders and equity holders) do not have to be compensated for bearing additional risk, therefore the cost of capital is lower. .

Based on Belden Company's cost structure, a 10 percent decline in sales would create a 14 percent decline in pre-tax operating profit. If Belden Company's sales were to increase by 15 percent, by what percentage would its pre-tax operating profit increase?

Based on the first sentence, we see that the degree of operating leverage is 1.4; so if a 15 percent change is multiplied by 1.4, it would be a 21 percent increase in operating profit.

Sixth National Bank stores all of its financial records in an electronic data base. Sixth National customers are able to access their accounts on-line with a user identification number and a password. Last weekend, a computer hacker was able to breach the firewall of the electronic data base and gain access to customer account data. This operational risk for Sixth National Bank is

Breach of an electronic data base with confidential customer data is a systems risk.

U.S. Petroleum Company would like to purchase oil drilling rights in another nation. That nation, however, is run by a dictator who last year confiscated another foreign company's oil equipment. U.S. Petroleum decided to enter the country through a joint venture with the dictator's brother who heads a small oil company. By entering the foreign nation through a joint venture, U.S. Petroleum was addressing which risk?

By entering the country through a joint venture, it reduces the risk that the company's equipment will be confiscated by the government, which is political risk.

Question 65. Which one of the following statements is true regarding the basic measures that apply to risk management?

Consequences measure the degree to which an occurrence could positively or negatively affect an organization.

Which one of the following types of financial risk has only negative potential

Credit risk has only negative potential.

Fire, wind, theft, business interruption, sickness and disability, and liability claims are all considered

Hazard risks. Correct. Fire, wind, theft, business interruption, sickness and disability, and liability claims are all considered hazard risks.

Data credibility refers to the level of confidence that

Data credibility refers to the level of confidence that available data can accurately indicate future losses.

Determining earnings-at-risk (EaR) entails modeling the influence of factors such as

Determining earnings-at-risk (EaR) entails modeling the influence of factors such as changes in the prices of products and production costs on an organization's earnings.

Determining the probability that a certain event will occur can be an important part of exposure analysis in the risk management process. Which one of the following is the term used for probability that is developed based on actual experience?

Empirical probability is the term used for probability that is developed based on actual experience

Jo is evaluating ABC Company's financial statements and has prepared a year-to-year trend analysis of the income statement, which is shown below: 20X4-20X3 20X3-20X2 20X2-20X1 Sales -0.5% 0.5% 0.5% Cost of goods sold -0.4% 0.5% 0.2% Gross profit -0,7% 0.5% 0.9% Selling, general & admin. expense -3.7% -3.6% -3.4% Operating profit 5.3% 9.5% 11.9% Interest expense 8.3% -5.9% 2.0% Earnings before taxes 4.6% 13.4% 14.8% Income taxes 6.6% 13.6% 10.6% Net Income 3.3% 13.2% 17.7% Which one of the following statements concerning the year-to-year trends for ABC is most accurate?

Even though sales have been flat for several years, ABC has been able to increase its profitability by reducing its operating expenses. .

Jepson Building Materials Company develops and produces innovative building material. One of their experimental products is a new form of sheet rock, which is commonly attached to a building frame. Their new product, "Thin Rock," is half as thick as traditional sheet rock and provides better insulation. The product, however, is very brittle. When the product was tested, some Thin Rock sheets shattered during installation and released a fine powder. Workers involved in the testing process began to complain of respiratory problems. Mindful of the experience with asbestos, Jepson decided to stop development of Thin Rock and the product was never released for sale. Jepson dealt with the risk of respiratory problems from Thin Rock through

Jepson dealt with the risk through risk avoidance.

Question 35. The financial crisis of 2008 highlighted the leverage of many global financial institutions and lead regulators to focus on risk-based capital. Leverage refers to

Leverage refers to using borrowed money to invest.

In financial statement analysis, what term refers to cash as well as short-term securities that can easily be converted to cash?

Liquidity tests emphasize cash as well as short-term securities that can easily be converted to cash.

Question 59. Jordan Brown is the risk manager of Bellows Company. The company has one key customer and one key supplier. Two years ago, Jordan made a change in how the company funds losses, shifting to greater use of retention and paying for retained losses through current income. Bellows Company is considering a change in its production process. The change would add greater fixed operating costs, but reduce variable costs. Based on the information presented, Jordan should be

Opposed to the change because it increases the chance of not having enough current income to pay retained losses. Increasing operating costs increases the variability of operating income, which is problematic because there is a key customer and a key supplier that could negatively impact sales.

Which one of the following statements regarding probability is correct?

Probabilities associated with events such as coin tosses can be developed from theoretical considerations and are unchanging.

Risk management professionals can use risk maps in several ways. One application assists risk managers in determining the difference between the risk remaining after the risk manager has applied risk treatment activities and the risk present before risk treatment measures have been applied. This difference is

Residual risk.

Based on the ISO 31000 definition of risk assessment, which one of the following steps includes determining the level of risk and its potential effects on the organization?

Risk analysis is the step of risk assessment that includes determining the level of risk and its potential effects on the organization.

Which one of the following is one of the five steps of the enterprise risk management (ERM) process model?

Scan environment is one of the five steps of the enterprise-wide risk management process model.

Question 20. Risk can be classified as subjective or objective. Which one of the following statements is correct with respect to these risk classifications?

Subjective risk can exist even where objective risk does not.

Which one of the following steps in the enterprise-wide risk management process includes an evaluation of how each of the organization's risk management processes aligns with its overall objectives?

The "scan the environment" step includes this evaluation

Question 68. Jancy Manufacturing has experienced an increase in employee injuries over the last three years. Jancy's risk manager has met with the various stakeholders throughout the organization and has the support of senior management to design and implement risk management framework and process. Which one of the following individuals would be the best person to communicate Jancy's commitment to risk management and employee safety?

The CEO would be the best person to communicate Jancy's commitment to risk management and employee safety.

Which one of the following team approaches to risk identification involves a select group of experts in question-and-response cycles until a consensus is achieved?

The Delphi technique involves a select group of experts in question-and-response cycles until a consensus is achieved

In loss analysis, the Prouty Approach primarily involves

The Prouty Approach primarily involves loss frequency and severity.

Which one of the following is an objective and consistent measurement tool that can be used by organizations to conduct periodic self-assessments?

The Risk Maturity Model (RMM) is an objective and consistent measurement tool that can be used by organizations to conduct periodic self-assessments. .

Which one of the following is an example of a liquidity ratio?

The acid-test ratio is an example of a liquidity ratio

The basic accounting equation on which the balance sheet is structured is

The basic accounting equation on which the balance sheet is structured is Assets = Liabilities + Net Worth.

The board of directors of Insurance Company wants assurance that the company's recently-instituted "commitment to risk management" has been communicated to and accepted by all company employees. Which one of the following ways would be the best technique to determine if employees had been informed of the commitment to risk management and had accepted it?

The best method to gauge acceptance of the "commitment to risk management" would be to administer a risk management questionnaire to the employees.

Which one of the following statements is true regarding central tendency when comparing the characteristics of probability distributions?

The central tendency is the one single outcome that occurs most frequently. Incorrect. The measures of central tendency represent the best guess as to what the outcome will be. B. Most probability distributions cluster around the exact center of the distribution's range of values. C. The most widely accepted ways of measuring central tendency are referred to as the average, the weighted average, and the mean. D. The measures of central tendency represent the best guess as to what the outcome will be. .

Which one of the following statements regarding the coefficient of variation is true?

The coefficient of variation is useful in comparing the variability of distributions that have different shapes, means, or standard deviations

The Committee of Sponsoring Organizations of the Treadway Commission (COSO) framework list five interrelated components of internal controls. Which one of the following components forms the basis for carrying out all of the organization's other functions?

The control environment component forms the basis for carrying out all of the organization's other functions.

Which one of the following statements is true regarding the evolution of risk and risk management?

The definition of risk has evolved to include positive as well as negative attributes. .

Which one of the following is the correct explanation of how expected accidental losses associated with a project should be considered when evaluating a capital budgeting project?

The expected accidental losses should be subtracted from cash revenues before taxes are considered.

Heritage Planners Ltd is a consulting group that provides company cars to management. The fleet of vehicles was recently sold for a gain of $5,000. The gain should be classified on the income statement as

The gain should be classified on the income statement as other income and expenses.

Insurance Company monitors key indicators of underwriting effectiveness. Some indicators they monitor include: percentage of business quoted that was written, application processing time, premium volume handled by underwriters, skill level of underwriters, and benchmarking between different underwriting offices. The indicators of underwriting performance Insurance Company uses are called

The key indicators of underwriting effectiveness that Insurance Company uses are control indicators. .

The most significant difference between the enterprise-wide risk management process and the traditional risk management process is

The most significant difference between the enterprise-wide risk management process and the traditional risk management process is the types of risk addressed

During the past year, International Toys has undertaken four capital projects. The company has renovated and refurbished one of its aging warehouse buildings. It has purchased the most recent version of its current order processing computer software. It has added two trucks to its fleet of delivery vehicles. Lastly, it has purchased a new production machine that will allow it to launch a new product line. Which one of the following company projects is the most speculative risk?

The new production machine project is the company's most speculative risk. .

The structure that supports the organization's risk management objectives and strategies is the

The risk management framework supports the organization's risk management objectives and strategies.

Question 52. Brenda is the new risk manager at Telecom Company. She did a preliminary analysis to identify organizational risks. Brenda then scheduled a meeting of the organization's leaders, key employees, and other stakeholders. Brenda asked her assistant, Brian, to moderate the session since he is skilled in risk identification, and he is a skilled communicator as well. Brian encouraged brainstorming, and asked follow-up questions. After the session, Brenda and her risk management colleagues had a much deeper understanding of Telecom's risks. The technique that Brenda applied is called a

The technique Brenda used is a facilitated workshop.

Harris Company is analyzing its workers compensation loss exposure. Harris Company retains most of the exposure and purchases excess insurance to cap its liability on any individual claim. Because Harris Company has a large work force, it can predict its workers compensation cost with some level of accuracy. For next year, the risk manager estimates that there is a 70 percent chance that workers compensation costs will be $6 million or less, a 25 percent chance workers compensation costs will be between $6 million and $8 million, and a 5 percent chance workers compensation costs will exceed $8 million. The type of analysis the risk manager performed is called

The type of analysis performed is called quantitative analysis.

A mortgage lender may compare the number of delinquent mortgage loans to the total number of loans outstanding. If the percentage exceeds a specified percentage, for example 10 or 20 percent, that may indicate that lending practices are too risky. This technique for identifying loss exposures is using

This technique for identifying loss exposures is using an escalation or threshold trigger.

Which one of the following statements is true regarding the use of personal inspections to identify loss exposures?

To be effective, personal inspections should be accompanied by discussions with front-line personnel who can identify nonobvious loss exposures. .

Fair value accounting uses the term market value surplus (MVS) for an organization's net worth. Which one of the following is the term used for an insurer's net worth under statutory accounting principles (SAP)?

Under SAP, an insurer's net worth is called policyholders' surplus.

Using existing processes is key to the successful integration of the risk management framework and process. Using existing processes serves which one of the following purposes?

Using existing processes reduces the usual resistance to change from introducing new procedures.

Question 56. Management must carefully consider the maximum amount of financial leverage it can use. Which one of the following is true when the level of debt increases to a point that it exceeds the earnings per share benefit?

When the level of debt increases to a point that it exceeds the earnings per share benefit, the value of the company will decline.

Question 72. Helen is a member of ABC Insurance Company's board of directors. She chairs the audit committee and is a member of the risk management committee. Helen ordered a review of company policies and procedures to make sure ABC managers were complying with company guidelines. This review found that one person could write checks for claims under $500 without a second person signing-off on the payment. Although no losses occurred, the small claims payment procedure was modified so that a second person had to approve issuance of the check. The review that Helen ordered is called

internal audit. .