Risk Management Exam 1
Priority Ranking of Coverages
- Essential: could cause bankruptcy - Important: losses require resort to credit - Optional: losses met from assets or cash flow
Social Insurance
-Based on the notion that there are some people in society who face fundamental risks that they cannot deal with themselves. -Social insurance programs rest on the premise that if an individual cannot provide for a reasonable standard of living through personal efforts, society should assist.
How is risk distinguished from a peril and a hazard?
-Peril: cause of loss (hurricane) -Hazard: a condition that creates or increases chance of loss (Brick home at time of hurricane vs mobile home or not following safety standards)
How does risk management contribute to organizational profit?
-Risk management is a scientific approach to dealing with risks by anticipating possible accidental losses and designing and implementing procedures that minimize the occurrence of loss or the financial impact of the losses that do occur. -Saves money when you prepare for possible losses
What are the two fundamental characteristics of insurance?
1. Transfer of risk from the individual to the group. 2. Sharing of losses on some equitable basis.
Common Errors in Buying Insurance
-Buying too much -Buying too little -Buying too much and too little at the same time
What are the two broad categories for dealing with risk?
1) Risk Control -Avoidance -Reduction 2) Risk Financing -Retention -Transfer
Classification of Private Insurance
1.Life Insurance 2.Accident and health Insurance 3.Property and liability insurance -property (fire) -marine -theft -liability -trade credit -fidelity and surety bonds
What is financial risk management?
Financial risk management: the management of financial risks, including credit risk, market risk, and liquidity risk
Fidelity and Surety Bonds
-Agreement by one party, the "surety," to answer to a third person, the "obligee," for the obligation of a party called the "principal." -If the principal fails to perform in the manner guaranteed, the surety will be responsible to the obligee. -The surety is analogous to the cosigner of a note and like a cosigner, is responsible for the obligation if the principal defaults.
Rules of Risk Management
-Don't risk more than you can afford to lose - Consider the odds - Don't risk a lot for a little
Fundamental vs Particular
-Fundamental out of our control impersonal in origin and consequences. Societal risks (held that society should deal with them rather than individuals) -Particular risks involve losses that arise out of individual events and are felt by individuals rather than the entire group (considered the individuals own responsibility that are properly addressed by the individual)
Risk Retention Techniques
-Intentional / Unintentional -Voluntary / Involuntary -RetentionFunded / Unfunded
What are the common risk categories in an enterprise risk management program?
-Market risk: The risk arising from adverse movements in market prices. -Credit risk: The risk arising form the potential that a borrower will fail to pay a debt. -Liquidity risk: The risk that the business will have insufficient liquid assets to meet obligations that come due. -Operational Risk: Fraud, breaches in internal controls, technology risks, and external events such as earthquake, flood, and war.
How are hazards classified?
-Physical: type of construction or location of your home at critical time -Moral: (aware) purposely cutting corners when building a home; not paying attention to things -Morale: (unaware) careless behavior when preventing issues -A fourth type of hazard--legal hazard should also be recognized: jurisdictions from the law; building codes
What are the three classifications of pure risk?
-Pure risk has an adverse effect on economic activity because it is risk that either has loss or no loss only. -The existence of this risk may be deterrent to economic activity and capital accumulation. -Investors will undertake new risks only if the return on the investment is sufficiently high enough to compensate for both the dynamic and static risks. -The cost of capital is higher in situations in which the risk is greater and the consumer must pay the higher cost of the goods and services or they will not be available.
Pure vs Speculative
-Pure risks involve the possibility of loss or no loss only. -Speculative risk involve the possibility of loss or gain. They're voluntarily accepted because of the possibility to gain.
Public Guarantee Insurance Programs
-Quasi social insurance programs, mainly in connection with financial institutions -Public Guarantee Insurance Programs are usually allied with the function of regulation -Insurance principle is used to protect lenders, depositors, or investors against loss resulting from failure of a financial institution
Other Facets of Insurable Risk
-Randomness -Adverse selection is the tendency of the persons whose exposure to loss is higher than average to purchase or continue insurance to a greater extent than those whose exposure is less than average -Economic feasibility: the cost of the insurance must not be high in relation to the possible loss or that the insurance must be economically feasible.
Other risks frequently identified in an enterprise risk management program include
-Reputational risk: the potential that negative publicity will cause a loss -Strategic risk: the risk of failing to successfully implement the firm's strategies -Compliance risk: the risk of failing to comply with laws and regulations.
The six characteristics of risk
-Static and dynamic -Fundamental and particular -Pure and speculative
Static vs dynamic
-Static would exist even in the absence of economic change, not a source of gain for society. -Dynamic result from changes in the economy (change in price levels, consumer taste, income, output) is a source of gain for society
What is the difference between pure and speculative risks?
-The distinction between pure risk and speculative risk is important because only pure risks are normally insurable. -Pure risks are those in which there is a chance of loss or no loss only. -Speculative risks involve the chance of loss or gain.
How does the law of large numbers fit into probability theory?
-The observed frequency of an event more nearly approaches the underlying probability of the population as the number of trials approaches infinity. -Even though we know the probability of "head" is .5, we know we cannot predict whether a given flip will be a head or a tail.•Given a sufficient number of "flips," we would expect the result to approach one-half "heads" and one-half "tails."•This common sense notion that probability is meaningful only over a large number of trials is recognition of the Law of Large Numbers.
Reduction: the second of the two specific tools of risk control
-The term risk reduction is used to define a broad set of efforts aimed at minimizing risk. -Other terms that were formerly used, and which have been displaced by the more generic term "risk reduction" include "loss prevention" and "loss control." -The term "risk reduction" is considered to include both loss prevention and loss control efforts. -some risk control efforts aim at reducing frequency, others seek to reduce the severity of the losses that do occur.
What is enterprise risk management?
-Traditionally, the risk management function was focused on the pure risks facing a business. More recently, interest has grown in a concept known as Enterprise risk management (ERM) which attempts to integrate the management of all of the firm's risks, both pure and speculative. -Common risk categories in an ERM program include: Market risk, Credit risk, Liquidity risk, Operational risk
What is risk?
-a condition in which there is a possibility of an adverse deviation from a desired outcome that is expected or hoped for. AKA possibility of loss -Risk not subjective - a state of the real world where the probability of an adverse event is between 0 and 1 -Risk is a state of the real world in which a possibility of loss exists, while uncertainty is a state of mind characterized by doubt or a lack of knowledge about the outcome of an event. -Risk can exist as a state of the real world even when the danger is not perceived and where there is therefore no uncertainty. -Uncertainty can exist where there is no risk.
What are the steps in the risk management process?
1. Determination of objectives 2. Identification of risks 3. Evaluation of risks 4. Consideration of alternatives - selection of the tool 5. Implementing the decision 6. Evaluation and review
What are the elements of an insurable risk?
1. Large numbers of exposure units 2. Definite and measurable loss 3. The loss must be fortuitous 4. The loss must not be catastrophic
Classifications of Pure Risk
1. Personal risks: consist of the possibility of loss of income or assets as a result of the loss of the ability to earn income. In general, earning power is subject to four perils: -premature death, -dependent old age, -sickness or disability, and -unemployment. 2. Property risks: embrace two types of loss: direct loss and indirect or "consequential" loss. ·Direct loss is the loss of the property itself, and is measured by the value of the property or the cost of repairing the property.·Indirect loss results from the loss of use of the asset that is damaged or destroyed, for the period required to repair or replace the property. 3. Liability risks: involve the possibility of loss of present assets or future income as a result of damages assessed or legal liability arising out of either intentional or unintentional torts, or invasion of the rights of others 4. Risks arising out of failure of others: When a person who has agreed to meet an obligation might fail to do so and such failure would produce financial loss, risk exists. •Examples of risks in this category include failure of a contractor to complete a construction project as scheduled, or failure of debtors to make payments as expected.
What are the three broad general classes of insurance and what are their characteristics?
1. Private insurance voluntary programs designed to protect individual against financial loss - Usually (but not always) voluntary. Usually (but not always) offered by private insurers. 2. Social Insurance compulsory insurance programs generally operated by government 3. Public Benefit Guarantee Programs quasi-social coverages usually associated with regulation
Social Insurance Definition
1.Coverage is compulsory 2.Eligibility derived from contributions: no requirement to demonstrate need 3.Method of determining benefits prescribed by law 4.Benefits not directly related to contributions 5.Definite long-range plan for financing 6.Cost borne primarily by contributions 7.Plan administered or supervised by government 8.Plan not established solely for government employees
How is probability defined?
1.Relative frequency interpretation: signifies the relative frequency of occurrence expected, given a large number of separate independent trials. 2.Subjective interpretation: probability is measured by the degree of belief (e.g., a student says she has a 50:50 chance of getting a B in a course).
Avoidance: one of the two specific tools of risk control
Avoidance takes place when decisions are made that prevent a risk from even coming into existence. While avoidance is the only alternative for dealing with some risks, it is a negative rather than a positive approach. Risk avoidance should be used in those instances in which the exposure has catastrophic potential and cannot be reduced or transferred.
How is standard deviation applied to decisions (see example in text)?
Like the variance, the standard deviation is a number that measures the concentration of the values about their mean. The smaller the standard deviation relative to the mean, the less the dispersion and the more uniform the values. The standard deviation is particularly useful in making estimates concerning the probable accuracy of this point estimate. Ina s ample with a lower standard deviation, we can be more confident in our estimate of the population mean.
What are the specific tools of risk control and risk financing and how are they used?
Risk avoidance and risk reduction.
Risk Retain: 2 of 2 specific tools of risk financing
Risk retention is the "residual" or "default" risk management technique, exposures that are not avoided, reduced, or transferred are retained. When nothing is done about a particular exposure, the risk is retained.
Risk Transfer: 1 of 2 specific tools of risk financing
Risk transfer is accomplished in several ways: Purchase of insurance, Hedging, Hold-harmless agreements, Subcontracting certain activities, Surety bonds
What are the specific tools of risk financing and risk financing and how are they used?
Transfer and Retain
What is adverse selection?
the tendency of the persons whose exposure to loss is higher than average to purchase or continue insur- ance to a greater extent than those whose exposure is less than average