University of Iowa Principles of Risk Management and Insurance Exam 1

Risk

uncertainty concerning the occurrence of a loss

(chance something can happen)

Loss Exposure

any situation or circumstance in which a loss is possible, regardless of whether a loss occurs

Objective Risk

the relative variation of actual loss from expected loss (standard deviations are used to calculate probability)

Subjective Risk

uncertainty based on a person's mental condition or state of mind

Chance of Loss

the probability that an event will occur

Objective Probability

the long-run relative frequency of an event based on the assumptions of an infinite number of observations and of no change in the underlying conditions

Subjective Probability

The individuals personal estimate of the chance of loss

Peril

cause of loss

Hazard

A danger or risk. Identifies more carefully what the risk actually is and causes an increase an the chance of a loss

Attractive Nuisance Hazard

When the loss causes an attraction for people to stop and watch what happened, which causes a hazard if they are driving, or gathering in the road, etc.

Physical Risk

Something that physical is dangerous and can cause a chance of loss.

Ex: A house that burned down recently found out the reason the fire was caused. There were oily rags next to the furnace and the furnace was overheating, which caught the rags and house on fire. The oily rags are the hazard.

Moral Risk

Being dishonest on an application

Ex: You lied and said you lost more than you actually did and the insurance company caught you. You will be labeled a moral risk

Attitudinal (Morale) Risk:

"you don't care"

Ex: Bob doesn't like seat belts and does not where them. Bob has had 7 seat belt violations and the insurance company will either raise the insurance, be labeled a high risk coverage, or be dropped completely from the company because he is a morale risk.

Legal Risk

The liability portion of the insurance policy.

Ex: If someone were to break their arm slipping on a rug in your home. The person responsible could be the homeowner, the person who broke their arm, and the rug company. They would all be labeled Legal risks

Speculative Risk

Chance of loss or gain (Insurance does not cover speculative risk)

Pure Risk

a risk that presents the chance of loss but no opportunity for gain (Insurance only covers pure risk)

Diversifiable risk

A risk that affects only some individuals, businesses, or small groups.

Ex: a car thief stole 4 cars would be a diversifiable risk because it affected a small group of people

Non-Diversifiable Risk

A risk that affects a large segment of society at the same time.

Ex: Hurricane Katrina

Enterprise Risk

encompasses all major risks faced by a business firm, which include: pure risk

speculative risk

strategic risk

operational risk

and financial risk

Strategic Risk

uncertainty regarding the firm's financial goals and objectives

Ex: A grandma wanted to buy a toy from Walmart, but the toy is held up in barge in a port somewhere because of covid. This toy company set a goal to sell X amount of toys and because of an uncontrollable circumstance they could not.

Operational Risk

results from the firm's business operations

Ex: A company didn't get computers like they should have. If they got the computers they could work a lot faster and make more money

Financial Risk

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

Enterprise Risk Management

combines into a single unified treatment program all major risks faced by the firm

Systemic Risk

Risk of collapse of an entire system or an 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

Property Risk

Involves the possibility of losses associated with the destruction or theft of property

Direct Loss

A financial loss that results from the physical damage, destruction, or theft of the property

Indirect Loss

A financial loss that results indirectly from the occurrence of a direct physical damage or theft loss

STARR

S: Self Insure

T: Transfer

A: Avoidance

R: Reduction

R: Retention

Self Insure

"I am going to insure myself"

Transfer

We are moving the risk from an individual to transfer that risk to an insurance company

Avoidance

We are completely avoiding that risk, making sure it does not happen

Reduction

We do everything we can to reduce the severity of the risk

Retention

Are sources of funds besides insurance

Law of Large Numbers

The law of large numbers is the mathematical foundation of insurance

Duplication

Refers to having back-ups or copies of important documents or property available in case a loss occurs

Seperation

means dividing the assets exposed to loss to minimize the harm from a single event

Diversification

Means spreading the loss exposure across different parties, securities, or transactions to reduce the chance of loss

Risk Financing

Refers to techniques that provide for the payment of losses after they occur

Methods of Risk Financing

1. Retention

2. Non-insurance transfers

3. Commercial insurance

Non-Insurance Transfers Advantages

-Can transfer some losses that are not insurable

-Less expensive

-Can transfer loss to someone who is in a better position to control losses

Non-Insurance Disadvantages

1. fails if you don't write contract right way

2. risk is transferred to someone who can't pay the loss, firm still responsible

3. may not give credit for the transfers, and insurance costs may not be reduced

Excess Insurance Policy (Umbrella Policy)

The insurer pays only if the actual loss exceeds the amount a firm has decided to retain

NOTE: you will have 2 deductibles if you use your umbrella policy, one for your original coverage and one for the umbrella policy

Insurance Advantages

- Indemnification

- Reduced Uncertainty

- Risk Mgmt. Services

- Premiums are Tax Deductible

Insurance Disadvantages

- Opportunity Costs

- Time and Effort

- Less Incentive to Reduce Risk

Frequency

Having a lot of claims

Severity

How much was damaged, which is generally caused from frequency

Top 4 areas of concern of business managers, corporate people, tax goers about what is going on

1. Cybersecurity Resilience 58%

2. Lack of actions taken to address climate change 40%

3. Pollution incidents and environment disasters 29%

4. Lack of diversity on board/ in workforce 27%

Risk Control

techniques that reduce the frequency or severity of losses

Loss Prevention

refers to measures that reduce the frequency of a particular loss

Loss Reduction

A risk control technique that reduces the severity of a particular loss

Financial Risk Management

the identification, analysis, and treatment of speculative financial risks

Call Option

Gives the owner the right to buy 100 shares of stock at a given price during a specified period

Put Option

gives the owner the right to sell 100 shares of stock at a given price during a specified period

Double-trigger Option

a provision that provides for payment only if two specified losses occur

Advantages of ERM Program

-improved risk assessment

-integrated response to the full range of risks

-alignment with organization's risk tolerance and its strategies

-fewer operational surprises and losses

-reduced earnings volatility

Barriers to successful ERM Program

-Rigid organizational culture

-Lack of committed leadership

-Turf battles between departments over

responsibilities

-Lack of a formal process

-Lack of information sharing and transparency

-Technological deficiencies

-Lack of commitment to the design and implementation of the program

Five Major Risk Techniques

S- Self-insure (sharing)

T- Transfer

A- Avoidance

R- Reduction

R- Retention

Pre-Loss Objectives

-Prepare for potential losses in the most economical way

-Reduce anxiety

-Meet any legal obligations

Post-Loss Objectives

-Survival of the firm

-Continue operating

-Stability of earnings

-Continued growth of the firm

-Minimize the effects that a loss will have on other persons and on society

Risk Management Process

1. Risk Identification

2. Risk Assessment (measuring and analyzing risk)

3. Risk Response Development (assigning the appropriate techniques)

4. Risk Response Control (implementing and monitoring)

Consequential Losses

A loss that arises as a result of direct damage to property (moral hazard & indirect loss)

Ex: Loss of rent

Example of avoidance

Not operating an automobile

Example of self-insure

Owners of a house on top of a large hill near a river may opt out of flood-plan insurance because they most likely will never need it

Example of transfer

Buying insurance

Example of Reduction

a fire department

example of retention

A company may retain the cost of damage to something minor and small like the damage to an outside small shed

Unfunded Retention

The most undesirable retention. It is when a company cannot afford to retain the costs (pay for the costs) of the loss.

The risk most suited to treatment by insurance are those with:

High Probability and High Severity

Example of a Pure Risk

Your house burning down, getting in a car accident, etc.

Example of a Speculative Risk

Gambling, investments, etc.

Example of a Systemic Risk

-Inflation

-Interest Rates

Example of a Financial Risk

-foreign investment risk

-credit risk

-market risk

Example of an Operational Risk

-Employee error on supply chain line

Example of a Strategic Risk

-The introduction of new products and services.

-When a merger or acquisition could be possibly unsuccessful

Risk Control Techniques

1. Avoidance

2. Loss Prevention

3. Loss Reduction

4. Separation

5. Duplication

6. Diversification

Example of Enterprise Risk

IT system failures

Hedging

A non-correlating investment designed to minimize known, quantified risk

Incorporation

Things combined or put together in one unit

Example of Liability Risk

A customer slipping and falling on a wet floor in your store

Example of Objective Risk

Assume that a fire insurer has 5000 houses insured over a long period and, on an average, 1 percent, or 50 houses are destroyed by fire each year. However, it would be rare for exactly 50 houses to burn each year and in some years, as few as 45 houses may burn. Thus, there is a variation of 5 houses from the expected number of 50, or a variation of 10 percent. This relative variation of actual loss from expected loss is known as objective risk.

Example of Subjective Risk

Some people think flying in an airplane is unsafe, some think its totally safe

Pooling

A group of small insurance firm group together to secure better rates and coverage plans by virtue of their increased buying power as a bloc.

Primarily used for securing health and disability insurance coverage

Reinsurance

Insurance for insurance companies

Underwriting

The process of selecting, classifying, and pricing applicants for insurance. (Insurers use this to determine the risks)

Deductible

a specified amount of money that the insured must pay before an insurance company will pay a claim on loss

Manuscript Policy

An insurance policy that is developed to meet a unique coverage need generally a one-of-a-kind of the insured

Seperation

When you disperse key assets so that a catastrophic event at one location does not affect the assets at another location.

Chief Risk Officer (CRO)

An executive responsible for a business's risk-management activities, which include the planning, controlling, preventing, and limiting of business losses and enhancing possibilities for gain

Combined Ratio

A measure of profitability used by an insurance company to indicate how well it is performing in its daily operations.

(incurred losses + expenses) / Earned Premium

Hard Market

A market that has more potential buyers than sellers

Soft Market

A market that has more potential sellers than buyers

Underwriting cycle: Soft Market

-profitability is improving

-standards are loosened

-premiums decline

-insurance become easier to obtain

Underwriting Cycle "Hard" market

-profitability is declining

-underwriting standards are tightened

-premiums increase

-insurance is hard to obtain