RMI Exam 1

Chapter 1-3, 5, 6, 8

A

What is the traditional definition of RISK?

A) uncertainty concerning the occurrence of loss

B) used to identify the property of life that is being considered for insurance purposes

C) “risk” is used when the probabilities of possible outcomes are known and “uncertainty” is used when such probabilities cannot be estimated

D) a fun thing to participate in

C

What is the insurance definition of risk?
A) a fun thing to participate in

B) “risk” is used when the probabilities of possible outcomes are known and “uncertainty” is used when such probabilities cannot be estimated

C) used to identify the property of life that is being considered for insurance purposes

D) uncertainty concerning the occurrence of loss

B

What is the definition of risk for economics/finance?

A) used to identify the property of life that is being considered for insurance purposes

B) “risk” is used when the probabilities of possible outcomes are known and “uncertainty” is used when such probabilities cannot be estimated

C) a fun thing to participate in

D) uncertainty concerning the occurrence of loss

loss exposure

any situation of circumstance in which a loss is possible, regardless of whether or not a loss occurs

objective risk

the relative variation of actual loss from expected loss (calculated by standard deviation); it is measureable

subjective risk

uncertainty based on a person’s mental condition or state of mind; perception

chance of loss

the probability that an event causes a loss will occur

objective

The chance of loss may be identical for 2 different groups, but ____________ risk may be quite different

peril

the cause of loss (ie property damage bc of fire/windstorm/lightning or damage to car bc of a collision)

hazard

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

physical hazard

a physical condition that increases the frequency or severity of a loss

moral hazard

a dishonesty or character defect in an individual that increases the frequency or severity of loss

attitudinal hazard

carelessness or indifference to a loss, which increases the frequency or severity of a loss

legal hazard

refers to characteristics of the legal system or regulatory environment that increase the frequency or severity of loss

pure risk

a situation in which there are only the possibilities of loss or no loss (ie earthquake)

speculative risk

a situation in which either profit or loss is possible (ie gambling)

diversifiable risk

affects only individuals or small groups (car theft); can be reduced or eliminated by diversification

nondiversifiable risk

affects the entire economy or large numbers of persons or groups within the economy (ie hurricane); AKA fundamental risk; government assistance may be necessary to insure this

enterprise risk

encompasses all major risks faced by a business firm which includes pure risk, speculative risk, strategic risk, operational risk, and financial risk

strategic risk

uncertainty regarding the firm’s financial goals and objectives

operational risk

results from the firm’s financial goals and objectives

financial risk

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

enterprise risk management

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

• by packaging major risks into a single program, the firm can offset one risk against another

• as long as all risks are not perfectly correlated, the firm can do this

• treatment of financial risks require the use of complex hedging techniques, financial derivatives, future contracts, and other financial instruments.

systemic risk

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

personal risks

risks that directly affect an individual or family; they involve the possibility of a loss or reduction in income, extra expenses, or depletion of financial assets due to premature death, retirement risks, poor health, unemployment, and alcohol/drug addiction

property risks

involve 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, such as fire damage to a home

indirect/consequential loss

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

liability risks

involve the possibility of being held legally liable for bodily injury or property damage to someone else

• no maximum upper limit w/respect to the amount of the loss

• a lien can be placed on your income and financial asserts

  • legal defense costs can be enormous

property, liability, and loss of business income risks

what risks can firms face?

property risks

examples include: damage to buildings, furniture, and office equipment

liability risks

examples include: suits for defective products, pollution, and sexual harassment

loss of business income

when the firm must shut down for some time after a physical damage loss

risk control

techniques that reduce the frequency or severity of losses (ie avoidance)

loss prevention

activities to reduce the FREQUENCY of losses

loss reduction

activities to reduce the SEVERITY of losses (ie duplication, separation, diversification)

risk financing

techniques that provide for the funding of losses

retention

an individual or business firm retains part or all of the losses that can result from a given risk

active retention

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

passive retention

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

self insurance

a special form of planned retention by which part or all of a given loss is retained by the firm

non insurance transfer

transfers a risk to another party (ie by contract like the Hold Harmless Clause in leases)

hedging

a technique for transferring the risk of unfavorable price fluctuations to a speculator

incorporation (of a business firm)

transfers the risk of having insufficient assets to the creditors

risk management

a process that identifies loss exposures faced by an organization and selects the most appropriate techniques for treating such exposures

loss exposure

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

pre-loss objectives

prepare for potential losses in the most economical way, reduce anxiety, and 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

1. Identify potential losses
   Measure and analyze the loss exposures

2. Select the appropriate combination of techniques for treating the loss exposures

3. Implement and monitor the risk management program

What are the steps in the risk management process?

avoidance

a certain loss exposure is never acquired or undertaken, or an existing loss exposure is abandoned (chance of loss is reduced to zero); it is not always possible or practical to avoid all losses

loss prevention

measures that reduce the frequency of a particular loss (ie installing safety features)

loss reduction

measures that reduce the severity of a loss after it occurs (ie installing an automatic sprinkler system)

duplication

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

separation

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

diversification

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

risk financing

techniques that provide for the payment of losses after they occur

retention

the firms retains part or all of the losses that can result from a given loss

current net income, unfunded reserve, funded reserve, or credit line

What are ways a risk manager can pay for retained losses?

current net income

losses are treated as current expenses

unfunded reserve

losses are deducted from a bookeeping account

funded reserve

losses are deducted from a liquid fund

credit line

funds are borrowed to pay losses as they occur

captive insurer

an insurer owned by a parent firm for the purpose of insuring the parent firm’s loss exposures

self-insurance (or self funding)

a special form of planned retention by which part or all of a given loss exposure is retained by the firm

Risk Retention Group

a group captive that can write any type of liability coverage except employers’ liability, workers comp, and personal lines; they are exempt from many state insurance laws

non insurance transfers

methods other than insurance by which a pure risk and its potential financial consequences are transferred to another party (ie contracts, leases, hold-harmless agreements)

deductible

a specified amount subtracted from the loss payment otherwise payable to the insured

excess insurance policy

a policy in which the insurer pays only if the actual loss exceeds the amount a firm has decided to retain

manuscript policy

a policy specially tailored for the firm

hard market

profitability is declining, underwriting standards are tightened, premiums increase, and insurance is hard to obtain

soft market

profitability is improving, standards are loosened, premiums decline, and insurance becomes easier to obtain

risk management policy statement

outlines the firms objectives and policies, educates top-level executives, gives the risk manager greater authority, and provides standards for judging to risk manager’s performance

personal risk management

the identification and analysis of pure risks faced by an individual or family, and to the selection of the most appropriate technique(s) for treating such risks

insurance

the pooling of fortuitous losses by transfers of such risks to insurers, who agree to indemnify insureds for such losses, to provide other benefits on their occurrence, or to render services connected with risk

indemnify

to promise to pay for another person’s losses, damages, or legal costs

pecuniary

relating to money/measured in moneyoften associated with financial loss or expenses.

risk transfer, indemnification, pooling of losses, and payment of fortuitous losses

what are the characteristics of an insurance plan?

fortuitous

meaning by chance

pooling

involves spreading losses incurred by the few over the entire group

Law of Large Numbers

the greater the # of exposures, the more closely will the actual results approach the probable results that are expected from an infinite number of exposures (larger sample size = the more predictable it is)

fortuitous loss

one that is unforeseen, unexpected, and occur by chance

pure risk

transferred from insured to insurer, who is typically in a stronger financial position

indemnification

the insured is restored to his/her approximate financial position prior to the occurrence of loss

large # of exposure units, fortuitous loss, determinable & measurable loss, no catastrophic loss, calculatable chance of loss, economically feasible premium

What are the characteristics of an ideally insurable risk?

adverse selection

the tendency of persons with higher than average chance of loss to seek insurance at standard rates

careful underwriting and policy provisions

Adverse selection can be controlled by _______ and _________

private insurance

life/health/property/liability insurance

government insurance

social insurance programs; found at both the federal and state levels ( ex: federal flood insurance, state health insurance pools)

life insurance

pays death benefits to beneficiaries when the insured dies

health insurance

covers medical expenses bc of sickness of injury

property insurance

indemnifies property owners against the loss or damage of real or personal property

liability insurance

covers the insureds legal liability arising out of property damage or bodily injury to others

causality insurance

covers whatever is not covered by fire, marine, and life insurance

financial services

retirement (ie 401l, Roth IRAs, IRAs, etc)

personal and commercial lines

What are the two categories of private insurance?

personal lines

coverages that insure the real estate and personal property of individuals and families or provide protection against legal liability

commercial lines

coverages for business firms, nonprofit orgs, and gov’t agencies

social insurance programs

financed entirely or in large part by contributions from employers and/or employees via payroll deduction, benefits heavily weighted in favor of low income groups; eligibility and benefits prescribed by law ( ie social security, unemployment compensation, workers compensation0

indemnification for loss, reduction of worry and fear, source of investment funds, loss prevention, enhancement of credit

What are the benefits of insurance to society?

expense loading

the amount needed to pay all expenses, including commissions, general admin expenses, state premium taxes, acquisition expenses & an allowance for contingencies and profit → fraudulent claims and inflated claims