Chapter 1: Risk and its Treatment Flashcards
Risk (traditional definition):
Uncertainty concerning the occurrence of a loss
Risk (in economics and finance)
used in situations where the probabilities of possible outcomes are known
Uncertainty
probabilities cannot be estimated
Loss exposure
Any situation or circumstance in which a loss is possible, regardless of whether a loss occurs
Objective risk vs probability
Risk: relative variation of actual loss from expected loss
probability: long-run relative frequency of an event based on the assumptions of an infinite number of observations and of no change in the underlying conditions
Subjective risk vs probability
risk: uncertainty based on a person’s mental condition or state of mind
prob: individual’s personal estimate of the chance of loss
Chance of loss
the probability that an event that causes a loss will occur
Peril
as the cause of the loss.
Hazard
a condition that creates or increases the frequency or severity of loss
Types of hazards
physical hazard: physical condition
moral hazard: dishonest/ character
attitudinal (morale) hazard: carelessness or indifference
legal hazard: legal system or regulatory environment
…which increase frequency or severity
Pure risk
situation in which there are only the possibilities of loss or no loss (earthquake) - no chance gain
Speculative risk
is a situation in which either profit or loss is possible (gambling)
Diversifiable risk affects
only individuals or small groups (car theft). It can be reduced or eliminated by diversification.
Non diversifiable risk affects
the entire economy or large numbers of persons or groups within the economy (hurricane). It is also called fundamental risk.
Enterprise risk
is a term that encompasses all major risks faced by a business firm, which include
Major risk of business firm
strategic risk, operational risk, and financial risk (+ pure risk, speculative risk)
Systemic risk:
is the 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
2008-2009 recession
Personal risk examples
Premature death
Retirement risks
Poor health
Unemployment
Alcohol and drug addiction
Direct loss versus indirect loss
A direct loss is a financial loss that results from the physical damage, destruction, or theft of the property, such as fire damage to a home
An indirect or consequential loss is a financial loss that results indirectly 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
The presence of risk results in three major burdens on society:
- Absence of insurance means must maintain large emergency funds to pay for unexpected losses
- The risk of a liability lawsuit may discourage innovation, depriving society of certain goods and services
- Risk causes worry and fear
Risk Control
refers to techniques that reduce the frequency or severity of losses:
Loss prevention vs reduction
Loss prevention: activities to reduce the frequency of losses
Loss reduction: activities to reduce the severity of losses:
Types of retention
Active retention - 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:
is a special form of planned retention by which part or all of a given loss exposure is retained by the firm
Traditionally, risk has been defined as
uncertainty concerning the occurrence of loss
The long-run relative frequency of an event based on the assumption of an infinite number of observations with no change in the underlying conditions is called
objective probability
Dense fog that increases the chance of an automobile accident is an example of a
physical hazard
A name that encompasses all of the major risks faced by a business firm is
enterprise risk
The premature death of an individual is an example of a
pure risk
Which of the following is a reason why premature death may result in economic insecurity?
I. Additional expenses associated with death may be incurred.
II. The income of the deceased person’s family may be inadequate to meet its basic needs.
Both
All of the following are burdens to society because of the presence of risk EXCEPT
The size of an emergency fund must be increased
Risk provides an incentive for people to engage in risk control
Society is deprived of certain goods and services
Mental fear and worry are present
Risk provides an incentive for people to engage in risk control
All of the following statements about risk retention are true EXCEPT
It may be used intentionally if commercial insurance is unavailable
It may be used passively because of ignorance
Its use is most appropriate for low-frequency, high-severity types of risks
Its use results in cost savings if losses are less than the cost of insurance
Its use is most appropriate for low-frequency, high-severity types of risks
ABC Insurance Company plans to sell homeowners insurance in five Western states. ABC expects that 8 homeowners out of every 100, on average, will report claims each year. The variation between the rate of loss that ABC expects to occur and the rate of loss that actually occurs is called
objective risk
Ben is concerned that if he injures someone or damages someone’s property he could be held legally responsible and required to pay damages. This type of risk is called a
liability risk
