FIN 360- Exam 1

Risk

-uncertainty concerning the occurrence of a loss

-Variation of outcomes

Loss Exposure

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

Objective risk

defined as the relative variation of actual loss from expected loss

Subjective risk

uncertainty based on a person's mental condition or state of mind

Pure risk

only the possibilities of loss or no loss (ex: premature death, job-related accidents, fire, lightening, flood)

Speculative risk

possibilities of both loss and gain (ex: stock purchase, horse racing, investing in real estate

Chance of loss

the probability that an event will occur

Objective probability

refers to the long-run relative frequency of an event assuming an infinite number of observations and no change in the underlying conditions

Subjective probability

refers to the individuals personal estimate of the chance of loss

Peril

defined as the cause of loss

Hazard

a condition that increases the frequency or severity of loss

physical hazard

physical conditions that increase the frequency or severity of loss

Moral hazard

dishonesty or character defects in an individual, that increase the frequency or severity of loss

Morale hazard

carelessness or indifference to a loss that increases the frequency or severity of loss

Legal hazard

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

diversifiable risk

affects only the individuals and small groups

nondiversifiable risk

affects the entire economy or large numbers of persons or groups

enterprise risk

encompasses all major risks faced by a business firm

Liability risks

- no maximum upper limit with respect to the amount of the loss

- a lien can be placed on your income and financial assets to satisfy a legal judgment

- legal defense costs can be enormous

Commercial risks

property risks, liability risks, loss of business income, other risks

Techniques for managing risks

avoidance, loss control, retention, non-insurance transfers, insurance

Loss control

loss prevention-- reducing the probability/frequency of loss

loss reduction-- minimizes the severity of loss

Rentention

-active retention

-passive retention

-self insurance

Priori probabilities

objective probabilities that can be determined by deductive reasoning

Definition of insurance

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

Pooling of losses

the spreading of losses incurred by the few over the entire group, so that in the process, average loss is substituted for actual loss

Payment of fortuitous losses

-insurance pays for losses that are unforeseen, unexpected, and occur 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

the insured is restored to his or her approximate financial position prior to the occurence of the loss

the law of large numbers

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

Payment of fortuitous losses

a loss that is unforeseen, unexpected and occur 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

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

Characteristics of ideally insurable risk

-Large number of similar exposure units

-Accidental and unintentional losses

-Determinable and measurable loss

-No catastrophic losses

-Calculable chance of loss

-Economically feasible premium

Fictional unemployment

after a person leaves a company, it naturally takes time to find another job

Cyclical unemployment

unemployment rises during recessionary periods and declines during periods of economic growth

Structural unemployment

technological changes lead to unemployment among workers displaced from jobs that are no longer needed

Institutional unemployment

government policies, such as high minimum wage floors, efficiency eages and discriminatory hiring, high rates of unionization

adverse selection

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

-if not controlled, adverse selection can result in higher-than-expected losses

-adverse selection can be controlled by careful underwriting and policy provisions

Insurance vs. Gambling

Insurance: Handles an already existing pure risk. Is always socially productive (both parties have a common interest in the prevention of a loss).

Gambling: Creates a new speculative risk and is not socially productive. (the winner's gain comes at the expense of the loser)

Insurance vs. Hedging

Insurance uses law of large numbers to reduce risk

Hedging transfers risk

Types of insurance

-Private Insurance - Life, Health, Property & Casualty

-Government Insurance - Social insurance programs

Social benefits of insurance

Indemnification for Loss

Reduction of Worry and Fear

Source of Investment Funds

Loss Prevention

Enhancement of Credit

Social costs of insurance

cost of doing business, fraudulent claims, inflated claims

What is risk management?

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

What is a loss exposure?

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

What are the objectives of risk management?

-Pre loss and post loss objectives

-Pre loss: prepares for potential losses in the most economical way

-Post loss: ensure survival of the firm, continue operations, stabilize earnings, maintain growth

Sources to identify loss exposures?

-questionanaires

-physical inspection

-flowcharts

-financial statements

-historical loss data

Risk control

refers to techniques that reduce the frequency and severity of losses

methods of risk control

avoidance

loss prevention

loss reduction

duplication

separation

diversification

risk financing

refers to the techniques that provide for the funding of losses

what are the different methods of risk financing

-retention

-non-insurance transfers

-commercial insurance

retention definition

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

Advantages and disadvantages of retention

Advantages:

Save on loss costs

Save on expenses

Encourage loss prevention

Increase cash flow

Disadvantages:

Possible higher losses

Possible higher expenses

Possible higher taxes

Advantages and disadvantages of insurance for risk management

Advantages

-firm is indemnified for losses

-uncertainty is avoided

-premiums are income-tax deductible

Disadvantages

-premiums may be costly; opportunity cost should be considered

-negotiation of contracts takes time and effort

-the risk manager may become lax to exercising loss control

non-insurance transfer

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

Advantages and disadvantages of non-insurance transfers

Advantages:

-can transfer some losses that are not insurable

-cost less than insurance

-can transfer loss to someone who is in a better position to control losses

Disadvantages

-contract language may be ambiguous, so transfer may fail

-if other party fails to pay, firm is still responsible for the loss

-insurers may not give credit for transfers