RMIN4000 Test 1 UGA

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Risk (Traditional Definition)

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124 Terms


Risk (Traditional Definition)

Uncertainty concerning the occurrence of a loss

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Risk (Better Definition)

A calculated possibility of a negative outcome

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Calculated Possibility

A probabilistic outcome (chance of loss, likelihood of loss) that is known or estimated | Ranges from 0 to 1 (0% to 100%)

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Negative Outcome

Loss (Must be Quantifiable (in $))

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How often does a loss occur? • The number of losses (such as fire, theft, collision) that occur within a specified time period. • Probability of a loss. • Ex: Probability of a fire is 0.0071 per loss exposure per year.

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How much does it cost when a loss does occur? • The dollar amount of loss for a specific peril (fire, theft, collision). • Example: Average structure fire loss is about $25,000

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Frequency Equation

of Losses / # of Exposures

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Severity Equation

Total Losses ($) / # of Losses

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Cause of Loss • Examples: Fire, windstorm, flood, collision, burglary, etc.

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A condition that creates or increases the frequency and/or severity of a loss. • Does not cause a loss. • Four types: 1. Physical 2. Moral 3. Morale (attitudinal) 4. Legal

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Physical Hazard

A physical condition that increases the frequency and/or severity of a loss

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Moral Hazard

The presence of insurance changes the behavior of the insured

Examples • Using a hammer to create “hail” damage to a roof. • Exaggerating the value of the insured property.

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Morale (Attitudinal) Hazard

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

Examples: • Leaving car keys in an unlocked car. • Neglecting a tree limb growing over your roof.

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Legal Hazard

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

Examples: • Juries in some jurisdictions are more sympathetic than other areas (meaning larger damage awards in liability lawsuits). • Georgia now requires Diminution in Value to be paid on property losses (meaning increased severity in Georgia).

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Risk Classifications

• Pure Risk vs. Speculative Risk • Diversifiable Risk • Nondiversifiable Risk • Enterprise Risk • Systemic Risk

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Pure Risk

  1. Loss

  2. No Loss

Ex: Auto Accident, Fire, Flood, Cancer, Slip & Fall

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Speculative Risk

  1. Loss

  2. No Loss/No Gain

  3. Gain

Ex: Investment, Gambling

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Diversifiable Risk

Affects only individuals or small groups, not the entire economy.

• Can be reduced/eliminated through diversification. (Have multiple facilities, cloud/backup data centers) • Risks are not correlated (For example: fire at multiple locations, theft, vehicle collision).

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Nondiversifiable Risk

Affects the entire economy or large numbers of groups/persons within the economy.

• Cannot be reduced/eliminated through diversification. • Government assistance may be needed to insure. • Risks are correlated (inflation, unemployment).

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Enterprise Risk

Encompasses all major risks faced by a business firm: • Pure Risk • Speculative Risk • Strategic Risk* • Operational Risk* • Financial Risk*

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Systemic Risk

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

• Instability in the financial system due to the interdependency between the players in the market.

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Major Types of Pure Risks

• Personal Risk • Property Risk • Legal Liability Risk • Loss of Business Income • Cyber-security

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Personal Risk

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

What perils might be involved? • Premature Death • Unemployment • Disability/Injury/Poor Health • Inadequate Retirement Income

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Property Risk

The possibility of losses associated with the destruction or theft of property.

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Direct Loss (Property)

Cost to repair or replace property damaged by a peril.

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Indirect Loss (Property)

Financial loss resulting as a consequence of a direct loss.

Examples: • Fire damages your home, you have to pay to live elsewhere while it’s repaired. • Fire damages a business the firm experiences Business Interruption, Loss of Income, extra expenses et al.

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Legal Liability Risk

Legal liability (financial consequences) resulting from injuries or damages you caused to someone else.

• Defense costs • No cap on losses (in most situations) • Liens can be placed on income, assets seized.

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Loss of Business Income

If a business has to shut down for a period of time due to a direct physical damage loss, it is unable to generate an income.

• Is this a direct or indirect loss? • Example – Grease fire in the kitchen causes a restaurant to close down for 4 weeks while repairs are made. The restaurant has no income while closed, but certain expenses continue.

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Burden of Risk On Society

• Larger Emergency Fund • Loss of Certain Good and Services • Worry and Fear

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Techniques for Managing Risks

  1. Risk Control

  2. Risk Financing

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Risk Control

Techniques to reduce the frequency or severity of losses

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Risk Financing

Techniques for funding losses

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Definition of Insurance

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

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Basic Characteristics of Insurance

  1. Pooling of losses

  2. Payment of fortuitous losses

  3. Risk Transfer

  4. Indemnification

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Law of Large Numbers

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

• Example: A coin flip has a 50%/50% chance of heads o But you could flip it 10 times and get 8 heads (80%). o The more times you flip it, the closer the percentage of heads will get to 50%.

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Pooling of Losses

The spreading of losses incurred by a few over the entire group.

• Purpose is to reduce variation (as measured by standard deviation) which reduces uncertainty (risk). • Think of standard deviation as the average distance from the mean.

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

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Risk Transfer

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

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

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Characteristics of an IDEALLY Insurable Risk

  1. Large number of exposure units.

  2. Loss must be accidental and unintentional.

  3. Loss must be determinable and measurable.

  4. Loss should not be catastrophic.

  5. Chance of loss must be calculable.

  6. Premium must be economically feasible.

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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.

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Loss Must be Accidental and Unintentional

Loss should be outside of insured’s control

Why? o Law of Large Numbers is based on randomness

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Determinable Loss

Can you determine if a loss occurred?

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Measurable Loss

Can you determine the amount of the loss?

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Loss Should Not be Catastrophic (to the Insurer)

Allows pooling technique to work

Examples of catastrophes • Terrorism • Hurricane / Named Windstorm • Flood • Earthquake

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Chance of Loss Must be Calculable

Must be able to calculate average frequency and average severity

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Premium Must be Economically Feasible

Insured must be able to afford it

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Adverse Selection

The tendency of persons with a higher-than- average chance of loss to seek insurance at standard (average) rates, which, if not controlled by underwriting, results in higher than expected loss levels

• Typically results from asymmetric information.

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Asymmetric Information

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

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Underwriting Risks

Process of selecting and classifying applicants for insurance

• Standards met • Coverage terms/exclusions to consider • Rates

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Types of Insurance

Private Insurance Government Insurance

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Private Insurance

Life, Health, Property & Casualty

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Government Insurance

Social insurance programs

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Life Insurance

Pays a death benefit to beneficiaries when an insured dies

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Health Insurance

Pays medical expenses because of sickness or injury. (Non work related injuries)

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Property Insurance

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

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Liability Insurance

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

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Casualty Insurance

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

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Categories of Property & Liability Insurance

Personal Lines Commercial Lines

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Personal Lines

• Private passenger auto • Homeowners’ “package” • Personal Umbrella Liability • Flood • Earthquake • Coastal Windstorm

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Commercial Lines

• Commercial Auto • Workers’ Compensation • Commercial General Liability • Premise Liability • Products Liability • Commercial Umbrella / Excess Liability • Flood • Earthquake • Coastal Windstorm • Inland Marine / Ocean Marine • Surety Bonds • Fidelity Bonds / Employee Dishonesty • Crime • Cyber • Others

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Government Insurance – Social Insurance Programs

Financed entirely or in large part by contributions from employers and/or employees

• Benefits are heavily weighted in favor of low-income groups • Eligibility and benefits are prescribed by statute

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Government Insurance – Social Insurance Programs Examples

  1. Old-Age, Survivors, and Disability Insurance (Social Security)

  2. Unemployment

  3. Medicare

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Other Government Insurance Programs

Found at both the federal and state level.

• Examples o Federal Deposit Insurance Corporation (FDIC) o National Flood Insurance Program (NFIP) o Fair Access to Insurance Requirements Plans (FAIR) o Beach and Windstorm Plans

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Risk Management

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

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Pre-Loss Objectives to RM

• Efficient cost of risk • Permits better decision making • Meet legal obligations

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Post-Loss Objectives to RM

• Survival of firm • Business continuity, earnings, growth • Societal

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Steps in the Risk Management Process

  1. Identify loss exposures.

  2. Measure and analyze the loss exposures.

  3. Consider and select the appropriate risk management techniques.

  4. Implement and monitor the chosen techniques.

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Step 1: Identify Loss Exposures

• What assets need to be protected? • What perils are those assets exposed?

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Important Exposures

• Property • Liability • Business Income • Human Resources • Crime • Employee Benefits • Foreign • Intangible • Regulatory

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Sources for Identifying Loss Exposures

• Meeting with management including risk manager • Financial statements • Loss history • Other firms/competitors • Risk management consultants • Surveys/questionnaires • Site Inspections • Review sales and purchase agreements • Flowcharts

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Step 2: Measure and Analyze the Loss Exposures

Estimate the frequency and severity of loss exposures. • Frequency (probability) – How often does the loss occur? • Severity (outcome) – How much does it cost when a loss does occur?

Analyze • Rank loss exposures according to relative importance. • Severity is more important.

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Maximum Possible Loss (MPL)

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

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Probable Maximum Loss (PML)

the worst loss that is likely to happen.

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Step 3: Consider and Select the Appropriate Risk Management Techniques

Risk Control Risk Financing

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Risk Control

Techniques that reduce the frequency or severity of losses

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Risk Financing

Techniques that provide for the funding of losses

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Risk Control - Avoidance

A certain loss exposure is never acquired (proactive), or an existing loss exposure is abandoned (reactive)

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Risk Control - Avoidance (Advantage)

Frequency is reduced to 0

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Risk Control - Avoidance (Disadvantage)

• May not be possible. • Usually has an opportunity cost. • Avoiding one loss exposure may create another.

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Risk Control – Loss Prevention

• Measures that reduce the frequency of a particular loss. • Does NOT completely eliminate risk.

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Risk Control – Loss Reduction

• Measures that reduce the severity of a loss. • No effect on the frequency of a loss

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Risk Control - Duplication

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

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Risk Control - Separation

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

Examples: • Firewalls in buildings • Have multiple data centers or warehouses

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Risk Control - Diversification

Reducing the chance of loss by spreading the loss exposure across different parties (customers, suppliers), securities (stocks, bonds), or transactions.

Examples: • Expanding customer base • Using multiple suppliers

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Risk Financing - Retention

A firm or individual retains part or all of the losses that can occur from a given risk

• Retention level • Active • Passive

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Retention level

the dollar amount of losses that the individual/firm will retain

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Deliberately retaining risk

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Unknowingly retaining risk

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When should risk be retained?

• No other option more attractive or available. • Worst possible losses are not serious (low severity). • Losses are predictable (high frequency; not catastrophic).

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Risk Financing – Retention (Types)

• Unfunded; cash flow • Funded Reserve • Deductible • Captive Insurer • Self-Insurance Plan • Risk Retention Group / Group Captive

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Risk Financing – Retention (Captive Insurance Company)

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

• Single-parent captive is owned by only one parent. • Association or group captive is an insurer owned by several parents

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Advantages of a Captive Insurance Company

• Can help a firm when insurance is too expensive or difficult to obtain. • Lower Costs o No agent or broker commissions. o Interest earned on invested premium. • Easier access to reinsurance market. • Possibility tax advantages. • Possibility of favorable regulatory environment.

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

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Risk Retention Group

• Group captives that can write any type of liability coverage except employers’ liability, workers' compensation, and personal lines.

• Exempt from many state insurance laws.

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Risk Financing – Noninsurance Transfer

Methods other than insurance by which a pure risk and its potential financial consequences are transferred to another party.

Examples • Contracts • Leases • Hold-harmless agreements

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Risk Financing – Commercial Insurance

Appropriate for low-frequency, high-severity loss exposures

These areas must be emphasized: 1. Selection of insurance coverages. 2. Selection of an insurer. 3. Negotiation of terms and services (risk control, claims, et al) 4. Dissemination of information concerning insurance coverages. 5. Periodic review of the insurance program.

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

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Excess insurance

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

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Manuscript policy

A policy specially tailored for the firm.

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