Risk Management Test 1

Risk

Calculated possibility of a negative outcome

Exposures

Things of value(assets) that could be lost

Peril

cause of a loss

risk management

what to do in order to protect these assets and/or prevent/reduce losses

Frequency

How often a risk occurs

Severity

the dollar cost when a loss occurs

Frequency equation

Number of losses / number of exposures

Severity equation

total losses($) / number of losses

Hazard

condition that creates or increases the frequency and/or severity of a loss; does not actually cause the loss

Moral Hazard

dishonesty or character defects in an individual that increase the frequency and/or severity of a loss; the presence of insurance changes the behavior of the insured

morale(attitudinal) hazard

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

legal hazard

characteristics of legal system or regulatory environment that increase the frequency and/or severity of a loss

pure risk

outcomes can only be loss or no loss; Can be insured; Ex: Fire, flood, and cancer

speculative risk

outcomes can be loss, no loss/gain, and gain; cannot be insured; Ex: investment and gambling

Diversifiable risk

affects only individuals or small groups; could be reduced/eliminated through diversification

non-diversifiable risk

affects the entire economy or large numbers of groups/persons within the economy; cannot be reduced/eliminated through diversification; Gov. assistance may be needed to insure

Enterprise Risk

encompasses all major risks faced by a business firm

Systemic Risk

risk of collapse of an entire system or market because of the failure of a single entity; instability in the financial system due to interdependency between players in the market

Personal Risk

Directly affects an individual or family; involves the possibility of loss of income, extra expenses, or depletion of financial assets

Property Risk

possibility of losses associated with the destruction or theft of property

Legal Liability Risk

Legal liability resulting from injuries or damages you caused to someone else; defense costs, no cap on losses, liens can be placed on income, assets seized.

Loss of Business Income

when a business has to shut down for a period of time due to a direct physical damage loss, it cannot generate an income.

Burden of Risk on Society

larger emergency fund; loss of certain good and services; worry and fear

Risk Control

techniques to reduce the frequency or severity of losses; loss prevention(frequency); Loss reduction(severity); Avoidance

Risk financing

Techniques for funding losses; retention; noninsurance risk transfer; insurance

Avoidance

technique is either never acquired(proactive) or an existing loss exposure is abandoned(reactive)

Retention

Retaining part or all of the losses that can occur from a given risk; Deliberately retaining the risk(active) or unknowingly retaining risk(passive)

Hedging

derivatives such as options, futures, etc.

insurance

pooling of accidental losses by transfer of risks to insurers, who agree to compensate insureds and to provide other monetary benefits on their occurrence, or to render services connected with the risk

Law of Large Numbers

The greater the number of exposures, the more closely will actual results expected from an infinite number of exposures;

Pooling of Losses

the spreading of losses incurred by a few over the entire group; purpose is to reduce variation

Payment of Fortuitous Losses

unforeseen and unexpected by the insured and occurs as a result of chance

Risk Transfer

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

indemnification

insured is restored to its approximate financial position prior to the occurrence of the loss

Large number of exposure units

enables the insurer to predict average loss based on the law of large numbers; large number of similar exposure units needed

Adverse selection

the tendency of persons with a higher-than-average chance of loss to seek insurance at standard rates; occurs due to asymmetric information

Asymmetric information

occurs when one party has information that is relevant to a transaction that the other party does not have

Underwriting Risks

process of selecting and classifying applicants for insurance

Life Insurance

pays a death benefit to beneficiaries when an insured dies

Health Insurance

pays medical expenses because of sickness or injury( non-work related injuries)

loss should not be catastrophic for what reasons?

allows pooling techniques to work; solutions for insurers are reinsurance and diversification

Property Insurance

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

Liability Insurance

covers the insured’s legal liability arising out of property damage or bodily injury to others

Casualty Insurance

broad term refers to insurance that covers whatever is not covered by fire, marine, and life insurance; includes auto, liability, and workers’ compensation

Government Insurance

Social insurance; financed entirely or in large part by contributions from employers and/or employees; benefits are heavily weighted in favor of low income groups; prescribed by statute

FDIC

Federal Deposit Insurance Corporation

NFIP

National Flood Insurance Program

FAIR

Fair Access to Insurance Requirements Plans

Pre-Loss

Efficient cost of risk; permits better decision making; meet legal obligations

Post-Loss

survival of firm; business continuity, earnings, growth; societal

Steps in the risk Management Process

Identify loss exposures; Measure and analyze the loss exposures; Consider and select the appropriate risk management techniques; Implement and monitor the chosen techniques

Maximum Possible Loss (MPL)

the worst loss that could happen to the firm during its lifetime

Probable Maximum Loss (PML)

the worst loss that is likely to happen

Loss Prevention

Measure that reduce the frequency of a particular loss; does NOT completely eliminate the risk

Loss Reduction

Measures that reduce the severity of a loss; no effect on the frequency of a loss

Duplication

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

Separation

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

Captive Insurer

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

Association (group captive)

an insurer owned by several parents

Advantages of a Captive Insurance Company

Can help a firm when insurance is too expensive or difficult to obtain; lower costs; easier access to reinsurance market; possibility tax advantages; possibility of favorable regulatory environment

Self-Insurance

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

Risk Retention Group

Group captive that can write any type of liability coverage except employer’s liability, workers’ compensation, and personal lines; are exempt from all laws, rules, regulations, or orders that would control their activities

Risk Retention Act of 1981

Amended in 1986, allows insurers underwriting all types of liability risks except workers’ compensation/employer’s liability to avoid cumbersome multistate licensing laws

Pros and Cons of Retention

Pros: save on loss costs, save on expenses, encourage loss prevention, and increase cash flow

Cons: possible higher losses, higher expenses, and higher taxes

Non-Insurance Transfer

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

Pros and Cons of Non-Insurance Transfer

Pros: can transfer some losses that are not insurable, less expensive, can transfer loss to someone who is in a better position to control losses

Cons: contract language may be ambiguous and transfer may fail, if the other party fails to pay, firm is still responsible for the loss, insurers may not give credit for transfers

Commercial Insurance

Appropriate for low-frequency, high-severity loss exposures

Deductible

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

Excess Insurance

A plan 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

Pros and Cons of Commercial Insurance

Pros: Firm can continue to operate, uncertainty is reduced, firm may receive valuable risk management services, premiums are income-tax deductibles

Cons: Premiums may be more costly, negotiation of policies takes time and effort, most policies are annual, risk manager may become lax in exercising loss control

Funded Reserve and loss prevention is used in ___________

High-frequency and low-severity losses

Unfunded retention is used in _____________

low-frequency and low-severity losses

Avoidance, Captive or RRG, and Loss Prevention/Reduction is used in ______________

High-frequency and high-severity losses

Insurance and Loss Reduction is used in __________________

Low-frequency and high-severity losses

Hard Insurance Market

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

Soft Insurance Market

Profitability is improving, standards are loosened, premiums decline, and insurance become easier to obtain

Risk Management Policy Statement

The objectives of the firm; policy with respect to treatment of loss exposures; provides standards for judging the risk manager’s performance

Benefits of Risk Management

Enables a firm to attain its pre-loss and post-loss objectives more easily; society benefits because both direct and indirect losses are reduced; can reduce a firm’s total cost of risk

When did risk management programs start to include speculative financial risks?

In the 1990’s

Enterprise Risk Managment

A strategic business discipline that supports the achievement of an organization’s business objectives by addressing its risks and managing the impact as an integrated risk portfolio

ERM Program

Considers all risks an organization faces across the entire enterprise; holistic/interconnected view of risk; typically headed by Chief Risk Officer (CRO) and used in large organizations; creates a “risk culture”

What are the top 5 risks in the Allianz 2022 Risk Barometer?

1. Cyber attacks 2. Business Interruption 3. Natural Catastrophes 4. Pandemic 5. Changes to legislation and “ESG”

Types of risk withing ERM

Hazard, operational, financial, and strategic

Hazard Pure Risk

Property/Business Interruption, Liability, and personnel

Operational Risk

Risks arising from day-to-day business operations; Ex: cybersecurity, supply chain, customer service, and manufacturing defects

Financial Risk

Risks arising from the changing conditions within financial markets including: commodity availability and prices, interest rates, credit risk, foreign exchange rates, and liquidity

Strategic Risk

External; Littler or no control over risk; must be in a position to respond

Regulatory/Compliance Risks

Ex: taxes, OSHA, SEC(Public Companies)

ERM Tools

Risk Score, Risk Register, and Risk Map

Risk Register

Chat that categorizes and describes risks

Risk Map

A graph that shows how frequent and severe specific risks are

Risk Score

metric to predict aspects of a risk

Pros of an ERM Program

Increase awareness and assessment of risk; integrated response to the full range of risks; alignment with the organization’s risk tolerance and strategies; Fewer operational surprises and losses; Greater compliance with regulatory and legal requirements; improved accountability, efficiency and decision making; Increase value of the organization

Challenges to an ERM Program

Dynamic; lack of comitment from senior leadership; Resistance to change; Communications

Importance of an ERM

It combines all risks into a single risk management program which allows the organization to offset one risk against another and reduce its overall risk

What did Palmer and Cay start as?

Marine Insurance

Responsibilities of a Broker

be able to set expectations, differentiate his/her client, extract the right information, and collaborate with the underwriters; Relationship heavy industry

Lloyd’s of London is a __________

Insurance Market

Lloyd’s of London started as a ________________

Coffee shop