FIN 401 review questions CH3

What is a captive insurer?

A captive insurer is an insurer owned by a parent firm for the purpose of insuring the parent firm's loss exposures

What is a risk retention group?

A risk retention group is a group captive that can write any type of liability coverage except employer liability, workers compensation, and personal lines. For example, a group of physicians may form a risk retention group to obtain malpractice insurance because professional liability insurance is difficult to obtain or too expensive to purchase.

Explain the following risk-control techniques. Avoidance Loss prevention Loss reduction Duplication Separation Diversification

Avoidance means that a loss exposure is never acquired, or an existing loss exposure is abandoned. The major advantage of avoidance is that the chance of loss is zero if the loss exposure is never acquired. However, abandonment may still leave the firm with a residual liability exposure from the sale of previous products. (2) Loss prevention refers to measures that reduce the frequency of a particular loss. For example, measures that reduce lawsuits from defective products include installation of safety features on hazardous products, warning labels on dangerous products, and quality control checks. (3) Loss reduction refers to measures that reduce the severity of a loss after it occurs. Examples include installation of an automatic sprinkler system, rehabilitation of injured workers with job-related injuries, and limiting the amount of cash on the premises. (4) Duplication refers to having back-ups or copies of important documents or property available in case a loss occurs. Examples include back-up copies of key business records (for example, accounts receivable) in case the original records are lost or destroyed, and back-up parts in case a key part breaks or must be replaced. (5) Separation means dividing the assets exposed to loss to minimize the harm from a single event. For example, a manufacturer may store finished goods in two warehouses in different cities. (6) Diversification refers to reducing the chance of loss by spreading the loss exposure across different parties (for example, customers and suppliers), securities (for example, stocks and bonds),or transactions. For example, having several different customers and suppliers rather than relying on one key customer or supplier reduces risk.

Explain the advantages of using a captive insurer in a risk management program.

Captive insurers have several advantages: The parent firm may have difficulty in obtaining certain types of insurance from commercial insurers, so a captive insurer can be formed to provide coverage. Insurance costs may be lower because of lower operating expenses, avoidance of an agent's or broker's commission, and retention of interest earned on invested premiums and reserves that commercial insurers would otherwise receive. A captive insurer provides easier access to a reinsurer. A captive insurer can be a profit center if the captive insures the parent firm and other parties as well.

Explain the advantages of using insurance in a risk management program.

Insurance has several advantages in a risk management program: The firm will be indemnified after a loss occurs. Uncertainty is reduced, which permits the firm to lengthen its planning horizon. Insurers can provide valuable risk management services, such as loss control, identification of loss exposures, and claims adjusting. Premiums are deductible for income tax purposes.

Explain the disadvantages of using insurance in a risk management program.

Insurance has several disadvantages in a risk management program: The payment of premiums is a major cost. Considerable time and effort must be spent in negotiating the insurance coverages. The risk manager may have less incentive to follow a risk control program, because the insurer will pay the claim if a loss occurs.

Explain the objectives of risk management both before and after a loss occurs.

Preloss risk management objectives include the goals of economy, reduction in anxiety, and meeting legal obligations. Postloss objectives include survival of the firm, continued operations, stability of earnings, continued growth, and social responsibility.

What conditions should be fulfilled before retention is used in a risk management program?

Retention can be used if no other method of treatment is available, the worst possible loss is not serious, or losses are highly predictable.

Explain the following risk-financing techniques. Retention Noninsurance transfers Insurance

Retention means that the firm retains part or all of the loss that can result from a given loss exposure. Retention can be active or passive. Active risk retention means that the firm is aware of the loss exposure and plans to retain part or all of it. Passive risk retention, however, is the failure to identify a loss exposure, failure to act, or forgetting to act. (2) Noninsurance transfers are methods other than insurance by which a pure risk and its potential financial consequences are transferred to another party. Examples include contracts, leases, and hold-harmless agreements. (3) Commercial insurance can also be used to fund losses. Insurance is appropriate for loss exposures that have a low probability of loss but the severity of loss is high.

Explain the meaning of risk control.

Risk control refers to techniques that reduce the frequency and severity of accidental losses. Specific techniques are avoidance, loss prevention, loss reduction, duplication, separation, and diversification.

Explain the meaning of risk financing.

Risk financing refers to techniques that provide for the funding of losses after they occur. Specific risk financing techniques include retention, noninsurance transfers, and insurance.

What is the meaning of risk management?

Risk management is defined as a systematic process for the identification and evaluation of pure loss exposures faced by an organization or individual and for the selection and administration of the most appropriate techniques for treating such exposures.

What is self-insurance?

Self-insurance is a special form of planned retention by which part or all of a given loss exposure is retained by the firm.

Identify the sources of information that a risk manager can use to identify loss exposures

Several sources of information can be used to identify potential losses. They are as follows: Risk analysis questionnaire and checklists Physical inspection Flow charts Financial statements Historical loss data

What is the difference between the maximum possible loss and probable maximum loss?

The risk manager must consider the maximum possible loss and probable maximum loss for each loss exposure. The maximum possible loss is the worst loss that could possibly happen to the firm during its lifetime. The probable maximum loss is the worst loss that is likely to happen.

Describe the steps in the risk management process.

There are four steps in the risk management process: (1) identify major and minor loss exposures; (2) measure and analyze the loss exposures in terms of loss frequency and loss severity; (3) select the appropriate technique or combination of techniques for treating the loss exposures; and (4) implement and monitor the program.