Principles of Risk Management and Insurance - Exam 1

the management of pure risks, both insurable and uninsurable

Traditional risk management

Most difficult step in risk management process

Identifying risks

Portion of the Gross Rate designed to pay losses

Pure Premium

Those who are responsible for the entire program of pure risk management (of which insurance buying is only a part) are

risk managers

Common Risk categories in an ERM program include (4):

Market risk

Credit risk

Liquidity risk

Operational risk

The risk arising from the potential that a borrower will fail to pay a debt.

Credit Risk

The greatest progress toward ERM has been in ___, where financial risk management is critical

financial institutions

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.

risk management

Two components of Risk Control

Avoidance

Reduction

Two Components of Risk Financing

Retention

Transfer

Buying insurance

Deep Pocket Theory

Transfer

encompasses all techniques aimed at reducing the number of risks facing the organization or the amount of loss that can arise from these exposures.

Risk Control

No more risk possible

risk avoidance

takes place when decisions are made that prevent a risk from even coming into existence.

avoidance

T or F: Risk avoidance should be used in those instances in which the exposure has catastrophic potential and cannot be reduced or transferred.

True

Risk transfer is accomplished in several ways: (5 examples)

purchase of insurance

hedging

hold-harmless agreements

Subcontracting

Surety bonds

Elements of an Insurable Risk (4)

Large numbers of exposure units

Definite and measurable loss

The loss must be fortuitous

The loss must not be catastrophic

T or F: Probabilities are ignored in the minimax regret strategy

True

Property and Liability insurers write __ & __

property and casualty (including health)

requires insurers to offer terrorism insurance to commercial insureds

Provides federal reinsurance to limit the insurer's potential loss.

Federal Terrorism Risk Insurance Act

a scientific approach to the problem of dealing with the risks facing individuals and organizations.

Risk Management

___ attempts to integrate the management of all of the firm's risks, both pure and speculative.

Enterprise Risk Management

The risk arising from adverse movements in market prices.

Market Risk

The definition varies. It includes a variety of pure risks, including technology risks, events such as fire, worker injury, CYBER RISK (#1 issue rn) etc.

Operational Risk

The risk that the business will have insufficient liquid assets to meet obligations that come due.

Liquidity risk

integrated management of all risks, pure and speculative

Enterprise risk management

the management of financial risks, including credit risk, market risk, and liquidity risk

Financial risk management

Broadly speaking, "loss prevention" efforts are aimed at preventing the

Occurrence of loss

consists of those techniques designed to guarantee the availability of funds to meet those losses that do occur.

Risk financing

All risks that cannot be avoided or reduced must be _______.

Transferred or retained

Intentional/Unintentional

Voluntary/Involuntary

Funed/Unfunded

Risk Retention Techniques

___ risk retention is always undesirable

Unintentional

___ retention results from the judgment that retention is the most effective means of dealing with the risk.

___ occurs when it is not possible to avoid, reduce, or transfer the exposure to an insurance company.

Voluntary

Involuntary

In a ___ retention program, the firm earmarks assets and holds them in some liquid or semi-liquid form against the possible losses that are retained.

Funded

Co-pay on your insurance when you go to the doctor is an example of

Risk Sharing

by managing pure risk, risk management increases the firm's ability to engage in __

speculative risks

Risk Management Process (6)

Determine the objectives

Identify risks

Evaluate risks

Consider alternatives

Implement decision

Evaluate and Review

Step in the risk management process most likely to be overlooked

Determining objectives

Pre-loss Objectives (4)

Economy

Reduction in Anxiety

Meeting externally imposed obligations

Social Responsibility

Post-Loss Objectives (4)

Survival

Continuity of operations

Continued Growth

Social Responsibility

The primary objective of risk management is to ___

preserve the operating effectiveness of the organization

Major policy decisions related to pure risks should be made by the __

highest policy-making body in the org (BoD)

Risk Identification: what it does and where it does it. Examples (X)

Inspections

Interviews

Examinations of records

Flow Charts

Internal Communication System

Questionnaires

Checklists

___ implies some ranking in terms of importance

Evaluation

___ suggests measuring some aspect of the factors to be ranked

Ranking

In case of loss, two facets that must be considered:

severity of loss

frequency/probability

Ranking of loss (3)

Critical (bankruptcy)

Important (borrowing)

Unimportant

is the worst loss that could occur, given the worst possible combination of circumstances.

maximum possible loss (MPL)

on the other hand, is the loss that is likely, given the most likely combination of circumstances.

probable maximum loss (PML),

the total of all financial losses that can result from a single event, taking into consideration the various exposures.

Loss Unit

T or F: Exposures characterized by low frequency should receive attention before exposures with a high frequency.

False; High, low

T or F: Exposures that exhibit a high loss frequency are often susceptible to improvement through risk control measures.

True

Evaluation and review of the risk management function is important for two reasons:

Things Change

Mistakes are made

Insurance has two fundamental characteristics

Transfer of risk from individual to group

Sharing of losses

an economic device whereby the individual substitutes a small certain cost (the premium) for a large uncertain financial loss (the contingency insured against) which would exist if it were not for the insurance.

Insurance

the body of knowledge concerned with measuring the likelihood that something will happen and making predictions based on this likelihood.

Probability Theory

signifies the relative frequency of occurrence expected, given a large number of separate independent trials.

Relative frequency 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).

Subjective interpretation

This common sense notion that probability is meaningful only over a large number of trials is recognition of the __

Law of Large Numbers

probabilities are based on observed frequencies of past events.

A posteriori

Definitional Impossibility

Self-Insurance

Classification of Private Insurance (3)

1) Life Insurance

2) Accident and health insurance

3) Property and liability insurance

Property (fire), marine, theft, liability, trade credit, fidelity and surety bonds

Property and Liability Insurance

One decision in risk management is to do ___

NOTHING

Major impediment to use of cost-benefit analysis in risk management decisions is that the ___ from the choices may be unknown

Costs

T or F: Where there is uncertainty about future costs, one can estimate expected costs from the potential payoffs and the probabilities of various outcomes

True

Decision Theory: the outcomes that result from each choice are known

Decision making under certainty

Decision Theory: the outcomes are uncertain but probability estimates are available for various outcomes.

Decision-making under risk

Decision Theory: the probability of occurrence of each outcome is not known.

Decision-making under uncertainty

The expected value criteria for retention and transfer decisions will always suggest ___ as the preferred choice

Retention

T or F: There are not situations in which the consequence (magnitude of potential loss) rather than the probability should be the first consideration

False - ARE

T or F: Even when dependable probability estimates are not available, decisions made under conditions of uncertainty can be made on a rational basis.

True

In ____ the decision maker attempts to minimize the maximum loss or maximum regret.

Minimax Regret Strategy

For problems such as those in risk management, where maximum costs are to be minimized, the maximum cost of each decision for each possible outcome is listed and the ___ is selected as the appropriate choice.

minimum of the maximums

T or F: Minimax regret is an appropriate strategy when the maximum cost associated with one of the outcomes is unacceptable to management.

True

the expected value strategy will always suggest ___ over ___

retention over insurance

minimax regret strategy will always suggest ___ over ___

transfer (insurance) over retention

3 Rules of Risk Management:

Dont risk more than you can afford to lose

Consider the odds

Don't risk a lot for a little

High Frequency, High Severity

Avoid

Reduce

Low Frequency, High Severity

Transfer

High Frequency, Low Severity

Reduce

Retain

Low Frequency, Low Severity

Retain

3 Common errors in buying insurance

Buying too much

Buying too little

Buying too much and too little at the same time

Priority Ranking for Insurance: (3)

Essential

Important

Optional

Insures against losses that could cause bankruptcy

Essential

Insures against losses that could be met from assets or cash flow

Optional

Insures against losses that would require resort to credit

Important

Building = $1 million

Insurance cost = $30k

Expected loss/yr = 20k

Predictable loss?

Risk?

20,000

980,000 risk

Most important service provided by the agent is probably ___

advice

One indicator of a knowledgeable and professional agent is a

professional designation

3 thoughts when selecting the insurer

1) financial stability

2) treatment of policyholders

3) Cost

5 Orgs that provide ratings for both life and health and property and liability insurers

A.M. best and Company

Fitch, Inc

Moody's

Standard and Poor's

TheStreet.com

A++, A+

Superior

A, A-

Excellent

B++, B+

Good

B, B-

Fair

C++, C+

Marginal

C, C-

Weak

D

Poor

E

Under State Supervision