Intro to Risk Management and Insurance: Exam #1

Risk

Uncertainty about whether a loss will occur

What are the two key elements of risk?

Uncertainty and loss

Risk Management

The process to best handle uncertainty about whether losses will occur

Loss Frequency

How often losses occur

What is loss frequency used for?

To predict how likely they are to occur

Loss Severity

The amount of damage resulting from losses and how much it will cost to pay for losses

What is loss severity used for?

To predict how costly future losses are likely to be

Chance of Loss

The probability that an event that causes a loss will occur

Pure Risk

A situation in which there are only the possibilities of loss or no loss

What is an example of a pure risk?

Earthquake

Speculative Risk

A situation in which either profit or loss is possible

What is an example of speculative risk?

Gambling

Diversifiable Risk

Affects only individuals or small groups

What is an example of a diversifiable risk?

Car theft

Can a diversifiable risk be reduced or eliminated by diversification?

Yes

Nondiversifiable Risk

Affects the entire economy or large numbers of persons or groups within the economy

What is an example of nondiversifiable risk?

Hurricane

What is a nondiversifiable risk also called?

Fundamental risk

What may be necessary to insure nondiversifiable risks?

Government assistance

Enterprise Risk

A term that encompasses all major risks faced by a business firm

What are the five types of enterprise risk?

Pure, speculative, strategic, operational, and financial

Strategic Risk

Refers to uncertainty regarding the firm’s financial goals and objectives

Operational Risk

Results from the firm’s business operations

Financial Risk

The uncertainty of loss because of adverse changes in commodity prices, interest rates, foreign exchange rates, and the value of money

Systemic Risk

The risk of collapse of an entire system or entire market due to the failure of a single entity or group of entities that can result in the breakdown of the entire financial system

Exercise: Several types of risk are present in the U.S. economy. For each of the bullet points, identify the type of risk that is present. Explain.

• The Department of Homeland Security alerts the nation of a possible attack by terrorists

• A house may be severely damaged in a fire

• A family head may be totally disabled in a plant explosion

• An investor purchases 100 shares of Microsoft stock

• A river that periodically overflows may cause substantial property damage to thousands of homes in the floodplain

• Home buyers may be faced with higher mortgage payments if the Federal Reserve raises interest rates at its next meeting

• A worker on vacation plays the slot machines in a casino

Enterprise Risk Management

A strategic business discipline that supports the achievement of an organization’s business objectives by addressing the full spectrum of its risks and managing the combined impact of those risks as an integrated risk portfolio

When does a loss occur?

When property or a right owned by a person or an organization has declined in value or a capacity to perform has been diminished

Loss Exposures

Possibilities of accidental losses with measurable financial consequences

What are the three elements of loss exposure?

• Value lost

• Cause of loss

• Financial consequences

Peril

The cause of the loss

What are some examples of peril?

Property damage because of fire

Hazard

A condition that creates or increases the frequency or severity of loss

What are the four types of hazards?

Physical, moral, attitudinal, and legal

Physical Hazard

A physical condition that increases the frequency or severity of loss

Moral Hazard

Dishonesty or character defects in an individual that increase the frequency or severity of loss

Attitudinal Hazard

Carelessness or indifference to a loss which increases the frequency or severity of a loss

What is an attitudinal hazard also called?

Morale hazard

Legal Hazard

Characteristics of the legal system or regulatory environment that increase the frequency or severity of loss

Exercise: Please state whether the following situation is a peril or hazard. If it is a hazard, please state its type.

• A house got struck by lightning

• Faking an accident to collect insurance proceeds

• Cathy’s car hit a patch of ice on the road

• Cathy drove her car with carelessness, because she knows that she has auto insurance

What are the four types of loss exposures?

Property, personnel, liability, and net income

What are the two types of property loss exposure?

Real and personal

Real Property

Land, buildings, and other structures attached to the land

Personal Property

Everything but real property

What are some examples of personal property?

Furniture, fixtures, and inventory

Ownership of real or personal property constitutes a _____ loss exposure.

Property

Direct Loss

A financial loss that results from the physical damage, destruction, or theft of the property, such as fire damage to a home

Indirect Loss

A financial loss that results indirectly from the occurrence of a direct physical damage or theft, such as the additional living expenses after a fire

What is indirect loss also known as?

Consequential loss

Employing personnel represents a _____ loss exposure through the possible death, disability, or injury of an employee.

Personnel

Liability

An individual or organization is legally responsible for the injury or damage suffered by another person or organization

What is considered a liability loss exposure?

The risk to the individual or organization of being liable for the injuries suffered by other people as a result of the fire

What are the reasons that liability loss exposure is important?

• There is no maximum upper limit with respect to the amount of the loss

• A lien can be placed on your income and financial assets

• Legal defense costs can be enormous

Net Income

The amount of revenues over expenses that is generated in a specific accounting period

What is a example of a specific accounting period?

A calendar year

What represents a net income loss exposure?

An individual or organization cannot earn the net income and would suffer economic loss

What are the benefits of risk management?

• Prevention of losses

• Reduction of the financial consequences of losses

• Peace of mind

Exercise: Classify each of the following loss exposures as (a) property, (b) liability, (c) personnel, or (d) net income.

• Jim might damage his car if it skids on an icy road and hits a tree

• Jim might cause injury to a passenger in his car as a result of the accident described in the situation above

• Jim might be injured in the accident and be unable to work

• Sarah owns an apartment house that might be damaged by a hurricane

• Sarah might lose rental income from her tenants because of damage caused by the hurricane

What is the risk management process?

Identifying and analyzing loss exposures → examining the feasibility of alternative techniques available for treating those exposures → selecting the most appropriate combination of those techniques → implementing the selected techniques → monitoring results and considering the need for change or improvement

What question do we ask to determine the values of property loss exposures? (Rita’s Case)

What does Rita’s personal property consist of?

What are the tools for identifying the values of property loss exposures? (Rita’s Case)

Surveys, questionnaires, and inspections

What question should we ask when looking for the causes of loss of property loss exposures? (Rita’s Case)

What are the various ways Rita’s car or its contents could be damaged, destroyed, or otherwise lost?

What question should we ask to determine the causes of loss of liability loss exposures? (Rita’s Case)

What are the various ways Rita’s car or its contents could be damaged, destroyed, or otherwise lost?

What are the tools for identifying the causes of loss of property loss exposures? (Rita’s Case)

Review the losses that have occurred to others, seek the advice of experts, and brainstorming

What are the tools for identifying the causes of loss of liability loss exposures? (Rita’s Case)

Collision and ?

What is needed to analyze the financial consequences of property loss exposures? (Rita’s Case)

Exposure identification and analysis require a dollar amount (repair or replace costs)

How are financial consequences with liability loss exposures determined? (Rita’s Case)

Losses can best be assessed with judgment, rather than measurement, possibly determined by a jury/judge

What are the tools for identifying the financial consequences of property loss exposures? (Rita’s Case)

Loss experience, expertise of others, purchase price

What are the tools for identifying the financial consequences of liability loss exposures? (Rita’s Case)

Loss experience and expertise of others

What are the personnel loss exposures for Rita’s case?

Rita could be disabled or killed as the result of an auto accident, diminishing, or eliminating her ability to earn a living

What are the net income loss exposures for Rita’s case?

Rita has routine expenses for gas, the maintenance of her car, fees for her driver’s license, tags, and registration, her car payments, and her car insurance premiums that must come out of her earnings or revenues which could unexpectedly be increased by maintenance problems with the car or fines for traffic violations

What is the tool for identifying and analyzing the hazards?

The preparation of a flowchart

Memorize the flowchart!

Memorize the flowchart!!

Memorize the identification and analysis diagram!

Memorize the identification and analysis diagram!!

What are the two categories of risk management techniques for treating loss exposures?

Risk control techniques and risk financing techniques

What are risk control techniques intended to do?

• Prevent losses

• Minimize the frequency or severity of losses

• Make losses more predictable

What are risk financing techniques intended to do?

To pay for those losses that occur despite the best risk control efforts

What are the five risk control techniques?

Avoidance, loss prevention, loss reduction, segregation of exposures, contractual transfer of an asset or activity

Avoidance

Choosing not to own an asset or engage in an activity that increases the possibility of loss

Which of the risk control techniques is often the least practical?

Avoidance

What is the avoidance technique the most practical technique for?

Large organizations with several alternatives available to them

What is an example of avoidance?

Avoid the risk of being mugged in a high-crime area by staying away from high-crime areas

Loss Prevention

Activities to reduce the frequency of a particular loss

What is an example of loss prevention?

Motorists take a safe-driving course and drive defensively

Loss Reduction

Activities to reduce the severity of losses

What is an example of loss reduction?

Using seat belts

How can segregation of exposures be accomplished?

Separation or duplication

Segregation of Exposures (Separation)

Relies on the dispersal of a particular activity or asset over more than one location

Segregation of Exposures (Separation) - Example

The owners of a clothing manufacturer store their inventory in several warehouses at different locations

Segregation of Exposures (Duplication)

Relies on having backups, spares, or duplicates of crucial assets readily available

Segregation of Exposures (Duplication) - Example

Back-up copies of key business records are available in case the original records are lost or destroyed

Contractual Transfer for Risk Control

Transferring the legal and financial responsibility of for a loss from one individual or organization to another

What is an example of contractual transfer for risk control?

Taking a taxi instead of driving cars

What are the two risk financing techniques?

Risk retention and risk transfer

Risk Retention

An individual or business firm retains part or all of the losses that can result from a given risk and plans to generate the funds to pay for losses themselves

Active Retention

An individual is aware of the risk and deliberately plans to retain all or part of it

What is an example of active retention?

A motorist may wish to retain the risk of a small collision loss by purchasing an auto insurance policy with a $500 or higher deductible

Passive Retention

Risk may be unknowingly retained because of ignorance, indifference, or laziness

When is risk retention appropriate?

High frequency, low severity risks where potential losses are relatively small

Risk Financing Transfer

Shifts the financial responsibility for losses from one party to another through a contract