Risk Management & Insurance Exam 1

Chapters 1 & 3

Risk

Uncertainty concerning the chance of a loss

Objective Risk

Expected loss vs actual loss

Law of Large Numbers

More trials = closer to predictions

Chance of Loss

Probability a loss happens

Objective Probability

Prove/statistical probability

Subjective Probability

Personal guess of probability

Peril

Direct cause of damage

Hazard

Anything that makes loss more likely/severe

Types of Hazards

Physical, Moral, Attitudinal, and Legal

Physical Hazard

Physical condition raising risk

Moral Hazard

Dishonesty raising risk

Attitudinal Hazard

Carelessness increasing risk

Legal Hazard

Laws/regulations raising risk

Pure Risk

Loss or nothing (no gain)

Speculative Risk

Loss, no change, or gain

Types of Pure Risk

Personal, Property, and Liability

Personal Risk

Risks to life/health/income

Property Risk

Risks to belongings

Liability Risk

Risks of being sued

Diversifiable Risk

Risk that can be spread out

Non-Diversifiable Risk

Risk that can’t be spread away

How often is the 10-k form filed?

Annually

How often is the 10-Q form filed?

Quarterly

How often is the 8-K form filed?

Reported on an as-needed basis

Technique classifications for treating loss exposures

Risk Control & Risk Financing

Categories of Risk

1. Pure Risk v. Speculative Risk

2. Non-diversifiable risk v. diversifiable risk

Step 1 of the Risk Management process (hint: most important step)

Identify Loss exposures

Step 2 of Risk Management Process

Measure and analyze the loss exposures

Step 3 of the Risk Management Process

Select the appropriate techniques for treating loss exposures

Step 4 of the Risk Management Process

Implement and monitor the risk management program

Measures of central tendency

Mean (expected value), median

Risk Matrix: Low frequency, high severity

Transfer

Risk Matrix: High frequency, high severity

Avoid

Risk Matrix: Low severity, low frequency

Retain

Risk Matrix: High frequency, low severity

Loss control (and retain)

Methods for identifying loss exposures

1. Risk Analysis Questionnaires

2. Physical Inspection

3. Flowcharts (flow of production and delivery, bottlenecks)

4. Financial Statements (SEC)

5. Contracts

6. Historical Loss Data

Loss prevention leads to…

reduction in frequency

Loss reduction leads to…

reduction in severity

Examples of loss reduction

1. Duplication

2. Separation

3. Diversification

Duplication

Backups / copies

Separation

Divide assets exposed to loss to minimize harm from a single event

Diversification

spreading loss exposures to reduce the chance of loss

Reasons for using retention

1. No other method available

2. The worst possible loss is NOT serious

3. Losses are highly predictable

Financial Resources contributing to the risk retention decision

1. Assets

2. Liquidity

3. Leverage

Risk management techniques that provide for the funding of losses after they occur

1. Retention

2. Noninsurance Transfers

3. Commercial Insurance

Risk Control Strategies (3)

1. Avoidance

2. Loss Prevention

3. Loss Reduction

Factors of the Risk Retention Decision

1. Financial Resources (assets, liquidity, leverage)

2. Feasibility (administrative issues, expenses)

Retention: Methods of Paying Losses

• Current Net Income

• Reserves

• Credit Line

  • Captive Insurance

Reasons to Form a Captive

1. Difficulty in obtaining insurance

2. Cost could be lower than purchasing commercial insurance

3. Could be a source of profit

Advantages of Retention

• save money

• lower expenses

• loss prevention

• increase cash flow

Disadvantages of Retention

• Higher costs

• Higher expenses

• Higher taxes

  • premiums for commercial insurance are generally tax-deductible

Types of Risk Finance Transfers

1. Noninsurance Transfer

2. Insurance

Types of Noninsurance Transfers

• contracts

• incorporation

  • defined benefit to defined contribution plans

Advantages of Non-Insurance Transfers

• Transfer risks for potential losses that are not insurable

• Can be less costly than insurance

• Shift risk to someone in a better position to exercise loss control

Disadvantages of Non-Insurance Transfers

• Transfer may fail if contract language is ambiguous

• Inability to pay

• May not affect insurance costs

When should you use commercial insurance?

Low probability, high severity events

What are risk managers responsible for?

1. Selecting insurer or insurers to provide coverage

2. Selecting coverages needed

3. Terms of the contract must be negotiated

A Deductible is a form of ______

retention

Commercial Insurance makes decisions regarding ________

Deductibles

Hard Market and Soft Market

Insurance Underwriting Cycles

Qualities of Hard Market

• tougher underwriting

• reduced capacity

• fewer competitors 

• higher premiums

• restricted coverage

Qualities of Soft Market (5)

Easier underwriting, Increased capacity, More competitors, Lower premiums, Broader coverage

Advantages of Insurance

• Indemnification

• Reduced uncertainty

• Risk Management Services

• Premiums are Tax Deductible

  • for commercial insurance

Disadvantages of Insurance

• opportunity costs

• time and effort to negotiate

  • less incentive to Reduce Risk 

Net Present (NPV) analysis

Present value of future cash flows minus the cost of a given project

Positive NPV?

Accept

Negative NPV?

Reject

What is the goal of Risk Management?

To reduce the Total Cost of Risk (TCOR): outlays reduce risk, opportunity costs, and expenses from financing potential losses, and cost of unreimbursed (retained) losses

Loss Frequency

Average number of times a loss occurs in a given time

Loss Severity

The financial size or seriousness of a loss

Risk Management

A process for identifying, measuring, and treating loss exposures

Loss Exposure

Potential for Loss

Risk Control

Techniques to reduce how often/bad losses are

Avoidance

Not facing the risk at all so a loss cannot occur

Retention

You pay for the loss instead of transferring it

Active Retention

Choosing to keep the risk

Passive Retention

Keeping risk without realizing it

Leverage

Borrowing to handle risk

Current Net Income

Pay from income

Reserves

Saving in advance for future losses

Credit line

borrowing to cover loss

Captive Insurance

Company insures itself

Premium

regular payment to keep insurance active

Noninsurance Transfers

Tansferring risk to another party through means other than insurance

Incorporation

limits liability to business assets

Defined Benefit to Defined Contribution Plans

Shifts retirement risk from employer to employee

Manuscript Policies

Custom insurance contracts for unique risks

Deductible (Commercial Insurance)

You pay first, insurer pays after

Excess Insurance (Commercial Insurance)

Coverage that pays only after a certain amount of loss is reached

Insurance Underwriting Cycles

Market cycles between tight insurance supply (hard market) and loose supply (soft market).

Hard Market

High premiums and strict coverage due to high losses

Soft Market Qualities

Low premiums and broaden coverage due to profitability and competition