1. Introduction to Risk Management

Question 0

Compare the terms possibility and probability.

1.1

Answer 0

Possibility does not indicate the likelihood of an event occurring, probability does.

Probability is measurable and has a value between 0 and 1.
p(x) = 0 is impossible
p(x) = 1 is certain
0 < p(x) < 1 is possible

Question 1

What two elements make up risk?

1.1

Answer 1

1. Uncertainty of outcome.

2. Possibility of a negative outcome.

Question 2

What is the difference between uncertainty and possibility?

1.1

Answer 2

Risk involves uncertainty about the type or timing of outcome (or both.) These result in the inability to accurately predict the future.

Possibility means that an outcome or event may or may not occur. Because of the possibility of a negative outcome, risk exists.

Question 3

How does classifying the various types of risk help in the risk management process?

1.2

Answer 3

Classification can help with

- Assessing risk
- Controlling risk
- Financing risk

Question 4

List the four broad classifications of risk outlined in the text.

1.2

Answer 4

1. Pure vs. speculative risk.
2. Subjective vs. objective risk.
3. Diversifiable vs. nondiversifiable risk.
4. Quadrants of risk.

Question 5

Compare pure and speculative risk.

Which type of risk does insurance primarily deal with?

1.2

Answer 5

Pure risk - chance of loss or no loss; no chance of gain, e.g. fire risk.

Speculative risk - chance of loss, no loss, or gain, e.g. stock purchase.

Insurance deals primarily with pure risk.

Question 6

Describe two types of speculative risk.

1.2

Answer 6

Examples of speculative risk

1. Financial investments
2. Business activities
   a. Price risk.
   b. Credit risk.

Question 7

Compare subjective and objective risks.

1.2

Answer 7

Subjective risk 
	- perceived amount of risk
	- based on opinion
Objective risk
	- measurable variation in outcomes
	- based on facts and data

Question 8

Why is it important to align subjective risk with objective risk?

1.2

Answer 8

The closer an organization’s subjective interpretation of risk is to the objective risk, the more effective its risk management plans are likely to be.

Question 9

What are the reasons that subjective risk can differ substantially from objective risk?

1.2

Answer 9

1. Familiarity and control

2. Severity over frequency

Question 10

Describe the difference between diversifiable and nondiversifiable risk.

1.2

Answer 10

Diversifiable risk
- affects a small portion of the population.
- e.g., fire destroying a factory
Nondiversifiable risk
- affects a large portion of the population.
- e.g., inflation increases building costs

Question 11

What types of risk do private insurance and government insurance address?

1.2

Answer 11

Private insurance tends to concentrate on diversifiable risks.

Government insurance is often suitable for nondiversifiable risks.

No clear line of demarcation exists.

Question 12

Name the “quadrants of risk” described in the text and used in enterprise risk management.

1.2

Answer 12

1. Hazard risks
2. Operational risks
3. Financial risks
4. Strategic risks

Question 13

Describe hazard risks.

1.2

Answer 13

Hazard risks are traditionally managed by risk management professionals.

Question 14

Describe operational risks.

1.2

Answer 14

Operational risks

• pure risks
• fall outside of Hazard Risk category
• could jeopardize:
  
  • service-related business functions.
  • manufacturing-related business functions.

Question 15

Describe financial risks.

1.2

Answer 15

Financial risks directly affect an organization’s financial position via changes in

a. revenue,
b. expenses,
c. business valuation,
d. the cost of capital, or
e. the availability of capital.

Question 16

Describe strategic risks.

1.2

Answer 16

Strategic risks
- are fundamental to an organization’s
existence and business plan
- have a current or future effect on earnings
or capital, due to
- adverse business decisions
- improper implementation of decisions
- lack of responsiveness to market
changes

Question 17

What are the three financial consequences of risk?

1.3

Answer 17

1. Expected cost of losses or gains
2. Expenditures on risk management.
3. Cost of residual uncertainty

Question 18

Describe what is included in the calculation of the expected cost of losses or gains.

1.3

Answer 18

Total cost of losses
= Direct costs + Indirect costs

The overall effect of losses is much greater than the cost of direct losses themselves

Question 19

Describe the difference in calculating the expected cost of losses or gains for speculative risks vs. pure risks.

1.3

Answer 19

Speculative risk
=> wider range of outcomes
=> calculation is more complex

Pure risk
=> narrower range of outcomes
=> calculation is simpler

Question 20

Describe expenditures on risk management in the context of financial consequences of risk.

1.3

Answer 20

Include

• cost of risk financing techniques
  
  • e.g., insurance
• risk control techniques
  
  • e.g., safety measures

Question 21

What is the cost of residual uncertainty?

1.3

Answer 21

The level of risk that remains after implementation of risk management plans.
- difficult to measure
- may have significant financial impact
- e.g., risk of expanding business
=> increase operational costs later
=> delay construction on new factory

Question 22

To minimize the adverse effects of lost or missed opportunities, what risk management efforts are undertaken?

1.4

Answer 22

Efforts to efficiently and effectively

a. assess risk.
b. control risk.
c. finance risk.

Question 23

What three elements does every loss exposure have?

1.5

Answer 23

Asset exposed to loss
Cause of loss (peril)
Financial consequences of loss

Question 24

Define a hazard in the context of property-casualty insurance.

1.5

Answer 24

A hazard is a condition that increases the likelihood and/or the severity of a loss.

Question 25

What four classifications for hazard do insurers typically use?

1.5

Answer 25

1. Moral hazard.
2. Morale hazard.
3. Physical hazard.
4. Legal hazard.

Question 26

For insurance and risk management purposes, loss exposures are typically divided into four types. Name them.

1.5

Answer 26

1. Property loss exposure.
2. Liability loss exposure.
3. Personnel loss exposure
4. Net income loss exposure.

Question 27

Name the four things that financial consequences of loss depend on.

1.5

Answer 27

1. Type of loss exposure.
2. Cause of loss.
3. Loss frequency.
4. Loss severity.

Question 28

Describe the possible financial consequences of loss due to a property loss exposure.

1.5

Answer 28

The maximum financial consequences are limited by the value of the property.

Question 29

Describe the possible financial consequences of loss due to a liability exposure

1.5.

Answer 29

The exposure to financial loss is theoretically unlimited.

In practice, consequences are limited to the total wealth of the individual or organization.

Question 30

Describe the financial consequence of loss to a personnel exposure.

1.5

Answer 30

Can be partial or total.

Can be permanent or temporary.

Question 31

The overall financial consequence of risk for a given asset or activity is the sum of what three costs?

1.6

Answer 31

1. The cost of the value lost because of actual events that cause a loss.
2. The cost of the resources devoted to risk management for that asset or activity.
3. The cost of residual uncertainty.

Question 32

Name the four benefits of risk management.

1.6

Answer 32

1. Reducing the financial consequence of risk.
2. Benefits to individuals
3. Benefits to organizations.
4. Benefits to society.

Question 33

Describe two ways in which risk management benefits individuals.

1.6

Answer 33

1. Preserves individual’s financial resources by reducing expected losses.
2. Reduces residual uncertainty associated with the risk.

Question 34

Describe three ways in which risk management benefits organizations.

1.6

Answer 34

1. Preserves an organization’s financial resources, making it a safer and more attractive investment.
2. Protection of capital makes the organization more attractive to suppliers and customers.
3. Reducing the deterrent effect of risk improves an organization’s capacity to engage in business activities.

Question 35

Describe two ways in which risk management benefits society.

1.6

Answer 35

1. Preserves society’s resources.

2. Reduces residual uncertainty, improving allocation of productive resources.

Question 36

Give three examples of ways in which reducing residual uncertainty results in an improved allocation of society’s resources.

1.6

Answer 36

1. Those who run organizations are more willing to undertake risky activities because they are protected.
2. Execs, workers, and investors are more able to pursue activities that maximize profits, wages or returns.
3. Such shifts increase productivity and improve the overall standard of living.

Question 37

What two categories are risk management program goals generally divided into?

1.7

Answer 37

1. Pre-loss goals

2. Post-loss goals.