EXAM 1 Flashcards
exposures
things of value (assets) that could be lost
examples: cars, health, life, money, future income
perils
things that could happen to these assets
examples: car accident, license revoked, breakdown, vandalism
risk management
things we can do to protect these assets or prevent/reduce losses
examples: drive safely, insurance, car alarm, lock vehicle
risk
calculated possibility of a negative outcome
calculated possibility
probabilistic outcome or chance of loss that is known or estimated
ranges from 0% to 100%
calculated possibility rain example
0% chance of rain = no risk
50% chance of rain = highest risk
100% chance of rain = no risk
negative outcome
a loss that must be quantifiable ($)
sometimes, loss cannot be quantifiable
frequency
how often does a loss occur
frequency equation
number of losses / number of exposures
severity
how much does it cost when a loss occurs
severity equation
total losses ($) / number of losses
expected loss equation
frequency x severity
hazard
a condition that creates or increases the frequency or severity of a loss
there are 4 types
4 types of hazards
physical
moral
morale
legal
physical hazard
physical condition that increases the frequency and/or severity of a loss
moral hazard
presence of insurance changes the behavior of the insured
example: when you have health insurance, you don’t think twice about going to check ups and getting strep tests, but if you don’t have health insurance, you think twice before spending your own money
morale hazard
carelessness or indifference to a loss which increases frequency and/or severity of a loss
example: leaving keys in an unlocked car
legal hazard
characteristics of legal system or regulatory environment that increase the frequency or severity of a loss
example: there are different juries in different places and at different times
pure risk
2 future states
loss or no loss
no chance of gain
speculative risk
3 future states
loss
no loss/no gain
gain
can you buy insurance for pure risk?
yes
can you buy insurance for speculative risk?
no
diversifiable risk
affects only individuals or small groups
can be reduced through diversification
risks ARE NOT correlated
nondiversifiable risk
affects the entire economy or large numbers of groups of people within the economy
cannot be reduced through diversification
risks ARE correlated
enterprise risk
encompasses all major risks faces by a business firm
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 a breakdown of the entire financial system
wobbly bridge video in class
major types of pure risk
personal
property
liability
loss of business income
cyber-security
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 with personal risk?
death
unemployment
injury
inadequate retirement income
property risk
possibility of losses associated with the destruction or theft of property
direct loss
cost to repair or replace property damage by a peril
indirect loss
financial loss resulting as a consequence of a direct loss
liability risk
legal liability resulting from injuries or damages you caused to someone else
there is no upper limit that someone could sue you for
loss of business income
if a business has to shut down for a period of time due to a physical damage loss and it is unable to generate an income
indirect loss
risk control
techniques to reduce the frequency or severity of losses
loss prevention
trying to reduce frequency of a particular loss
example: airport security to reduce frequency of danger
loss reduction
reduces the severity of a loss
example: sprinklers reduce severity of fire
duplication
having multiple copies on important things in case of a loss
separation
keeping assets physically separated to minimize harm from a single event
diversification
spreading the loss exposure across different parties, securities, or transactions
avoidance
technique in which certain loss exposures is never acquired (proactive) or an existing loss exposure is abandoned (reactive)
advantage of avoidance
frequency of loss is reduced to zero
disadvantage of avoidance
may not be possible
usually has an opportunity cost
avoiding one loss exposure may create another
risk financing
techniques for funding losses
retention
retaining part or all of losses that can occur from a given risk
active retention
deliberately retaining risk
passive retention
unknowingly retaining risk
noninsurance transfer
transferring the risk from one party to another typically in a contract
insurance
risk financing technique where you pay a small premium to agree to insure any of your loss exposures
risk management
process that identifies loss exposures faced by an organization and selects the most appropriate techniques for treating such exposures
loss exposure
any situation or circumstance in which a loss is possible, regardless of whether a loss actually occurs
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
identify loss exposures
what assets need to be protected?
what perils are those assets exposed to?
THIS IS THE MOST IMPORTANT STEP!
sources for identifying loss exposures
loss history
financial statements
other firms/competitors
risk management consultants
surveys/questionnaires
inspections
contract analysis
flowcharts
measure and analyze the loss exposures
measure:
estimate the frequency and severity of loss exposures
analyze:
rank loss exposures according to relative importance
maximum possible loss
the worst loss that could happen to the firm in its lifetime
probable maximum loss
the worst loss that is likely to happen
consider and select the appropriate risk management techniques
risk control
1. avoidance
2. loss prevention
3. loss reduction
4. duplication
5. separations
6. diversification
risk financing
1. retention
2. noninsurance transger
3. insurance
implement and monitor the chosen techniques
risk management policy statement outlines:
the risk management objectives of the firm
the company policy with respect to treatment of loss exposures
should be periodically reviewed and evaluated
retention techniques
unfunded retention
funded reserve
deductible
captive insurer
self-insurance
risk retention group
unfunded retention
not setting money aside for possible loss exposures
if the loss exposure is low risk and low severity
funded reserve
putting money aside specifically for a loss exposure
deductible
how much you pay out of pocket for a loss exposure
if your deductible is 1,000 this means you pay 1,000 before your insurance kicks in
captive insurer
insurer owned by a parent firm for the purpose of insuring the parent firm’s loss exposures
creating an insurance company for your company that only insures your company
self-insurance
special form of planned retention by which part of all of a given loss exposure is retained by the firm
also called self-funded
risk retention group
type of group captive that can write any type of liability coverage except employers’ liability, workers compensation, and personal lines
advantages of retention
save os loss costs
save on expensese
encourage loss prevention
increase cash flow
disadvantages of retention
possible higher losses
possible high expenses
possible higher taxed
noninsurance transfer advantages
can transfer some losses that are not insurable
less expensive
can transfer loss to someone who is in a better position to control losses
noninsurance transfer disadvantages
contract language may be ambiguous, so transfer may fail
if the other party fails to pay, firm is still responsible for the loss
insurers may not give credit for transfers
excess insurance
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
high frequency high severity
avoidance
captive group
loss prevention/reduction
high frequency low severity
funded reserve
loss prevention
low frequency low severity
unfunded retention
low frequency high severity
insurance
loss reduction
hard markets
insurer profitability is declining
underwriting standards are tightened
premiums increase
insurance is hard to obtain
soft markets
profitability is improving
standards are loosened
premiums decline
insurance becomes easier to obtain
insurance
pooling of fortuitous (accidental) losses by transfer of such risks to insurers, who agree to indemnify (compensate) insureds for such losses, to provide other pecuniary (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 the results will actually be to the true result
pooling of losses
the spreading of losses incurred by a few over the entire group
purpose is to reduce variation (SD) which reduces uncertainty (risk)
lower the standard deviation
the lower the risk
fortuitous/accidental losses
unforeseen and unexpected by the insured and occurs as a result of chance
if you attempt to buy homeowners insurance when a hurricane is approaching, is a wind loss fortuitous?
no
risk transfer
pure risk is transferred from the insured to the insurer, who typically is in a stronger financial position
indemnification
the insured is restored to its approximate financial position prior to the occurrence of a loss
characteristics of an ideally insurable risk
- large number of exposure units
- loss must be accidental and unintentional
- loss must be determinable and measurable
- loss should not be catastrophic
- chance of loss must be calculable
- premium must be economically feasible
large number of exposure units
enables the insurer to predict average loss based on the law of large
large number of similar exposure units is needed
adverse selection
the tendency of persons with a higher than average chance of a loss to seek insurance at a standard average rates which results in higher than expected loss levels
asymmetric information
occurs when one party has information that is relevant to a transaction that the other party does not have
credit based insurance score
utlize a consumer’s credit history to predict the likelihood of future insurance losses
high number = less likely to have a loss
types of private insurance
life insurance
health insurance
property insurance
liability insurance
casualty insurance
life insurance
pays death benefits to beneficiaries when the insured dies
health insurance
covers medical expenses because of sickness or injury
property insurance
indemnifies property owners against the loss or damage of real or personal property
liability insurance
covers the insured’s legal liability arising out of property damage or bodily injury to others
casualty insurance
refers to insurance that covers whatever is not covered by fire, marine, and life insurance
government insurance - social insurance programs
financed entirely or in large parts by contributions from employers and or employees
social security
unemployment
medicare
evolution of traditional risk management
in the 1990s, many companies began expanding their risk management programs to include speculative financial risks
Enterprise risk management
a strategic buisiness discipline that suports the achievement of an organization’s business objectives by addressing the full spectrum of its risks and managing the combined impact of those risks as an integrated risk portfolio
types of risk within ERM
hazard risk
operational risk
financial risk
strategic risk
hazard pure risk
traditional risk management types of risks - property, liability, etc
