RISK MANAGEMENT EXAM 1

Risk is defined as…

Uncertainty concerning the occurrence of a loss.

Objective risk is…

The relative variation of actual loss from expected loss (measured with standard deviation).

As the number of exposure units increases, the actual loss experience approaches the expected loss. This is known as…

The Law of Large Numbers.

The probability that an event causing a loss will occur is called…

Chance of loss.

An individual’s personal estimate of the chance of loss is called…

Subjective probability.

A statistical, long-run relative frequency of an event under stable conditions is called…

Objective probability.

The cause of loss is called a…

Peril

A condition that increases the chance of loss is called a…

Hazard

A dishonest act such as arson for profit is an example of a ______ hazard.

Moral hazard

Carelessness or indifference to loss because insurance exists is an example of a ______ hazard.

Attitudinal hazard

Court rulings that increase liability awards are an example of a ______ hazard.

Legal hazard

A physical condition that increases the chance of loss (e.g., icy roads) is a ______ hazard.

Physical hazard

A risk where the outcome is either loss or no loss is called a…

Pure risk.

A risk where the outcome could be loss, no loss, or profit is called a…

Speculative risk

Investing in the stock market is an example of a ______ risk.

Speculative risk

Premature death, poor health, or unemployment are examples of ______ risks.

Personal risks

The financial loss from physical damage or theft of property is a ______ loss.

A: Direct loss

A financial loss resulting indirectly from a direct loss (e.g., lost income from a fire) is a ______ loss.

Indirect or consequential loss.

Liability risk is the risk that…

You may be held legally liable for bodily injury or property damage to another.

A risk that affects only individuals or small groups is…

Diversifiable risk.

A risk that affects the entire economy or large groups (e.g., recession) is…

Non-diversifiable risk

Risk management is the process of…

Identifying, evaluating, and treating loss exposures

The most important step in the risk management process is…

Identifying loss exposures

Techniques for identifying loss exposures include…

Questionnaires, physical inspection, flowcharts, financial statements, contracts, historical loss data.

The probable number of losses in a time period is…

Loss frequency.

The probable size of a loss is…

Loss severity.

The worst loss that could happen to a firm during its lifetime is…

Maximum possible loss.

The worst loss that is likely to happen is…

Maximum probable loss.

Techniques that reduce the frequency or severity of loss are called…

Risk control.

Techniques that provide for the funding of losses are called…

Risk financing.

Avoiding a risk altogether (P(loss)=0) is called…

Avoidance.

Installing car alarms, training employees, or using non-slip flooring are examples of…

Loss prevention.

Backups, asset separation, and diversification are examples of…

Loss reduction techniques.

When a firm retains part or all of a given loss, this is called…

Retention.

A conscious and deliberate decision to assume risk is…

Active (planned) retention.

Failing to recognize or underestimating the potential loss is…

Passive retention.

An insurer owned by a parent firm to insure its own exposures is called a…

Captive insurer.

A contractual clause that shifts liability to another party is an example of…

Noninsurance transfer

Buying an insurance policy is an example of…

Risk transfer (via commercial insurance).

Higher deductibles generally mean…

Lower premiums (inverse relationship).

The insurer pays only if the actual loss exceeds the retained amount under…

Excess insurance.

A period where underwriting is strict, premiums rise, and coverage is harder to obtain is called a…

Hard market.

A period where underwriting loosens, premiums fall, and coverage is easier to obtain is called a…

Soft market

The ultimate goal of risk management is to…

Reduce the Total Cost of Risk (TCOR).

Formula for Expected Value (EV)?

EV = Σ (Loss Amount × Probability).

Example for Expected Value (EV): Loss outcomes: $0 (55%), $50,000 (20%), $100,000 (15%), $200,000 (10%).

EV = (0 × 0.55) + (50,000 × 0.20) + (100,000 × 0.15) + (200,000 × 0.10)
EV = 45,000 → $45,000

Formula for Standard Deviation (σ)?

A: σ = √ Σ [ (x – μ)² × P(x) ].

Example for Standard Deviation : Losses: $2m, $7m, $15m (equal probability).

Variance = [(2–8)² + (7–8)² + (15–8)²] ÷ 3 = 28.7.
σ = √28.7 = 5.36m

Formula for Coefficient of Variation (CV)?

CV = σ / μ (expressed as %).

Example for coefficient of variation : σ = $3m, μ = $25m.

CV = 3 ÷ 25 = 0.12 → 12%

Formula for Normal Distribution range?

μ ± (z × σ), where z = 1 (68%), 2 (95%), 3 (99%).

Example for normal distribution : μ = $25m, σ = $3m.

99% range = 25 ± (3 × 3) = 25 ± 9 = $16m to $34m

Maximum Possible vs. Maximum Probable Loss?

• Maximum possible loss = absolute worst case.

• Maximum probable loss = worst likely case (with safeguards).
  Example: Explosion without safeguards = $42m; with safeguards = $5m.
  Possible = $42m; Probable = $5m

Formula for Net Present Value (NPV)?

NPV = (Σ [ Cₜ / (1+r)ᵗ ]) – C₀.

Example for Net Present Value : Cost = $50,000. Savings = $15,000/year for 5 years, r = 8%.
Discounted inflows = 59,889.

NPV = 59,889 – 50,000 = +9,889 → Invest