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Intro To Risk Management > Exam 1 > Flashcards

Exam 1 Flashcards

1
Q

Pure Risk

A

-Uncertainty
-Focus of Traditional Risk Management
-Losses can be known with certainty
Impossible loss has 0% chance of happening
-No Risk Present/No uncertainty: budget and plan to avoid the loss
-Loss is still present, no uncertainty about loss
-Risk does not equal loss

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2
Q

Probability of a Loss

A
  • chance of a loss
  • probability ranges from 0-1, or 0%-100%
  • Risk does equal probability of a loss
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3
Q

Pure Vs. Speculative Risk

A
  • Both involve uncertainty
  • Difference is in outcomes
  • Risk does not equal probability of a loss
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4
Q

Speculative Risk

A

-3 future states
1. Gain
2. Loss
3. Break Even
Basis for Enterprise Risk Management (ERM)

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5
Q

Pure Risk

A

2 Future States

  1. Loss
  2. No Loss
    - fire, flood, death, sickness
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6
Q

Static Risk

A
  • Does not change significantly over time

- Always present

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7
Q

Dynamic Risk

A

-Arises out of changing circumstance

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8
Q

Subjective Risk

A
  • An individual’s view of uncertainty or the situation involving risk
  • Depends on the individual’s attitude toward risk
  • Not easily measured
  • Not easy to compare
  • Influence how a firm or decision maker will handle risky situations
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9
Q

Objective Risk

A
  • Risk is uncertainty concerning a loss
  • Variation is key; variation of actual outcomes around or about expected outcomes
  • Expected Loss (EL) - based on experience, data or other means, what we expect to happen
  • Actual Loss (AL) - Losses that actually occur
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10
Q

Sources of Pure Risk

A
  1. Human Capitol
  2. Retirement/Unemployment
  3. Property/Liability
  4. Wealth Losses
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11
Q

Human Capitol

A
  • Personal Pure Risk

- Ability to generate income

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12
Q

Retirement/Unemployment

A
  • loss or reduction in income

- possible higher medical expenses

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13
Q

Property/Liability

A

-ownership of financial or physical assets
-theft, damage - property pure risk
Direct Loss - cost of replacing the asset, cost of repair
Indirect Losses - extra expenses, loss of income

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14
Q

Wealth Losses

A
  • Judgment from lawsuit

- Legal Fees

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15
Q

Factors Affecting Risk

A
  1. Peril
  2. Frequency
  3. Severity
  4. Hazard
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16
Q

Peril

A

Immediate cause of the loss

-fire, flood, theft, etc

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17
Q

Frequency

A

How often do the losses occur

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18
Q

Severity

A
  • How bad

- severity is conditional upon frequency

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19
Q

Hazard

A
  • Underlying condition behind frequency
  • increases frequency
  • increases severity and frequency
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20
Q

Physical Hazard

A
  • Location
  • Construction-
  • Use
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21
Q

Location

A
  • If peril is flood then living at shore is physical hazard (frequency)
  • If peril is fire, then distance to fire hydrant is physical hazard
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22
Q

Construction

A

-Fire peril; wood structure is physical hazard (frequency and security)

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23
Q

Use

A
  • University Class vs. Church

- fire is peril, use of building as church poses more physical danger than university class

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24
Q

Moral Hazard

A
  • Act differently because of the existence of insurance
  • frequency or severity increases
  • car stolen to collect insurance money, arson on house to collect insurance
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25
Q

Moral Hazard Common Thread

A
  • Presence of Insurance

- Change of Behavior

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26
Q

Moral Hazard in Health Insurance

A
  • Cash Bar vs. Open Bar
  • Those with healthcare consume more than those without it
  • Price is fixed for those with insurance
  • Lowers user cost
  • Lower cost equals higher demand
  • Not bad behavior but costs more in the end
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27
Q

Morale Hazard

A
  • Carelessness concerning losses

- Has nothing to do with existence of insurance

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28
Q

Financial Consequences of Risk

A
  • What does risk cost an organization
  • How does risk impact an organization
  • How can that impact society?
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29
Q

Expected Cost of Loss

A
  • Financial losses-lawsuit and legal fees

- Goodwill and loss - loss of reputation

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30
Q

Cost to Manage Risk

A
  • Safety Programs
  • Training
  • Buy Insurance
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31
Q

Residual Uncertainty

A
  • Loss of goods or services because they are deemed too risk- society loses something valuable
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32
Q

Risk Making Process

A
  • Manage Pure Risk (TRM) and speculative risk (ERM)

- Goal is to minimize the financial impact on an organization

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33
Q

Function in Firm

A
  • Continuously Evolving

- Does not equal insurance buying

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34
Q

Evolution

A
  • 1950s, did not manage risk, just bought insurance
  • Mid 1960s Snider (Temple) coins term (RM)
  • Becomes strategy
  • 1950s very narrow and non-strategic
  • Present - very important function in a firm, very broad
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35
Q

Steps in RM Process

A
  1. Identify Exposure to Loss
  2. Evaluate Exposure to Loss (4)
  3. Identify possible alternatives (5+6)
  4. Select among the alternatives (7)
  5. Implementation of the chosen options (9)
  6. Reevaluation periodically the chosen strategy
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36
Q

Loss Exposure

A
  • Possibility of a financial loss that a particular entity faces as the result of a peril striking a thing of value : Stuff Happens
  • Most crucial step
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37
Q

How to Identify Loss Exposures

A
  • Inspections
  • Contract Analysis
  • Hold Harmless Agreements
  • Look at Past Information: does not work in all situations, Dynamic Risk
  • Share information with other similar firms
  • Checklist/Standardized Surveys from insurance companies
  • Flow Chart Approach
  • Ask employees/managers in the firm
  • Financial Statement Approach: Balance Sheets, Assets (Physical, Non-Physical)
  • Liabilities - income statement, who owes money, sources of revenue
  • Budget
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38
Q

Types or Categories of Loss Exposure

A
  • Property
  • Net Income
  • Personnel
  • Liability (Topic 3)
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39
Q

Property Loss Exposure

A
  • Real Property (land, building)
  • Personal Property: tangible (equipment), intangible (goodwill, patent)
  • Legal Interest in Property:
    1. Financial (stake in property)
    2. Ownership: most common, present or future
  • Buyers and Sellers
  • Shipping Products
  • FOB (Freight on Board Point), Ebay example
  • Balie Interest
  • Tenant Interest
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40
Q

Bailee Interest

A
  • Entity that receives property from another under a contract of bailment
  • Interest for bailee is legal liability to return or cost to replace the property
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41
Q

Tenant Interest

A
  • Continued Use

- Responsibility for returning property in reasonable condition

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42
Q

Net Income Loss Expenditures

A
  • Business Interruption
  • A firm suffers a primary loss - as the result suffers a secondary loss that results in indirect expenses
  • Normal production process is interrupted
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43
Q

Events That Cause Net Income Loss

A
  • Damage to property owned by firm
  • Delivery truck is stolen: extra costs - retail and orders not filled
  • Damage to property owned by others: key supplier has a property loss
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44
Q

Personnel Loss Expenditures

A
  • key employee suffers personal loss
  • loss of income
  • medical expenses
  • personal issue
  • firms may also suffer: decrease in revenue: sales down, decisions not made
  • increase in expenses - cost of replacing the person
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45
Q

Liability loss Exposure Plus ERM

A
  • Bad behavior
  • Breaking a contract
  • Behavior classified as either intentional or unintentional
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46
Q

Negligence and Liability

A

-L.L. established when: negligence, loss or damage

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47
Q

What Constitutes Negligence

A
  • Failure of a person to exercise the proper degree of care
  • Burden of proof is on the injured party
  • Absolute Strict Liability
  • L.L. established because accidents happen
  • Imposed whether anyone was at fault: children, workers comp
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48
Q

Measurement Issue

A
  • Usually easy to establish injury or damage occurred

- Establishing amount is usually difficult

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49
Q

Measurement of Loss

A
  • Property losses (PD)
  • Bodily Inury (BI): special damages
    1. compensate of measurable losses
    2. easy to calculate
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50
Q

Measuring Bodily Injury Damages

A
  • General Damages:
    1. Compensate for intangible losses
    2. Pain and Suffering
    3. Mental Anguish
    4. Difficult to estimate and measure - why?
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51
Q

Punitive Damages

A
  • Amounts assessed as a form of punishment
  • Gross Negligence is involved
  • Difficult to estimate and measure - why?
52
Q

Defenses of Liability

A
  • Assumption of risk by the injured party
  • One recognized the dangers involved in an activity
  • Voluntarily chooses to encounter it: attending a hockey game
  • Comparative/Contributory Negligence: plaintiff was partially to blame for what happened
53
Q

Res Ipsa Loquitoc

A
  • The thing speaks for itself
  • Modification to law of negligence
  • Presumption of negligence on part of defendant
  • Fact of injury is sometimes enough
  • Requirements:
    1. Would not occur without negligence
    2. Defendant exclusively controls tool/equipment
    3. Injured party does not contributor to loss: dentists remove wrong teeth
54
Q

Vicarious Liability

A
  • Negligence of two or more parties, contributes to the injury or damage
  • Injured party may recover the entire amount of compensation from any negligent party who is able to pay, regardless of the degree of that party’s negligence
  • Search for deep pockets
55
Q

Product Liability

A
  • Manufacturers of a faulty product that inures someone or damages property, may be held L.L.
  • Negligence - negligently designed, proper warning not given to consumer
56
Q

Product Liability Losses

A
  • Cost of defending and paying claims for injury
  • Cost of recalling any batches of products suspected of being defective
  • Damage to your name
57
Q

Premises Liability

A
  • Owner or tenant may be held liable for damages if someone is injured
  • If property of others is damaged as a result of a condition in or arising out of the premises
    3 Categories: Trespasser, Licensee, Social Guest/Invitee
58
Q

Trespasser

A

Someone who comes without right or consent, only obligated to abstain from doing intention harm

59
Q

Licensee

A

Comes onto property with knowledge of owner, no purpose or benefit to owner, must warn of hidden dangers

60
Q

Social Guest/Invitee

A

Been invited for some purpose, customer in store, must keep premises safe so no harm comes

61
Q

Animal Liability

A

Exotic Animals - Strict Liability
Dogs:
- Some states have strict liability
- Some states- if dog never bit before could escape liability

62
Q

Enterprise Risk Management

A
  • Manage and Sieze Opportunity
  • Risk based approach to managing an enterprise
  • Very Strategic
  • Scientific Approach
63
Q

Hazard Risk

A
  • Fire
  • Floods
  • Lawsuits, Liabilities
64
Q

Financial Risk

A
  • Prices
  • Volatility
  • Liquidity
  • Credit
  • Interest Rates Risk
65
Q

Operational Risks

A
  • Arise out of business operations
  • Manufacturing Products: supply chain service provider failures, system failure, product recall
  • Regulatory Issues
  • Employment Practices/Company Policies and Procedures: discrimination, turnover, workplace violence
66
Q

Strategic Or Business Risk (SWOT)

A
  • Customer Service Issues
  • Public Relations
  • Competition
  • Ethical Issues
  • Social Trends
67
Q

TRM Vs ERM

A
  • TRM is silo or departmentalized approach
  • TRM focuses mainly on hazard type risks (flood, fire, etc)
  • Financial type risks handled by CFO, Finance or accounting
  • Other Risks Maybe Handled by their specific areas
  • Not much effort to make relative comparisons among various risks to understand the cumulative impact on a firm
68
Q

ERM

A
  • ERM is an integrated approach
  • occurs at enterprise level instead of individual departments
  • RM activities heavily impact business decision
  • Designed to facilitate comparison and evaluation
  • Identify risks and determine if risks are correlated or independent
  • CRO in charge - can override department functional areas-
69
Q

Measurement/Evaluation of Exposure to Loss

A
  • Step 2 in RM process

- Risk: Uncertainty, variation around expected losses vs. actual

70
Q

Expected Loss = P*

A
  • Core of RM decision making
  • P* and the variation around it; planned losses, expected severity, E(X)
  • Basis for insurance pricing
71
Q

Gross Premium

A
  • Premium charged for insurance exposure unit
  • Must cover all costs of insurers
  • Insurer does not know all of the costs until the last claim is settled
  • Losses, expenses, administration
  • Gross Premium = Pure Premium + Loading Risk Charge
72
Q

Pure Premium: P*

A
  • Amount of gross premium sufficient to pay for losses only (P*)
  • It must be an estimate; can be wrong
  • Actual losses may not be equal to expected losses; Break Even, Profit, Loss
  • Insurers face an additional risk - estimation risk
73
Q

Risk Charge

A
  • Reflects the estimation of risk for an insurer
  • Needed because P* is an estimate
  • Cushion
74
Q

Influences Size of Risk

A
  • Accuracy of estimation of P*
  • If confident of P*, small risk charge: Life, Auto, Homeowners- small charge
  • If not confident of P*, risk charge is very high: Terrorism Risk, Internet Risk
  • Big events such as Superbowl or Olympics
75
Q

Intermediate Risk Charge

A
  • Natural disasters - floods

- Some liability risks

76
Q

Loading

A
  • General Office expenses/Fixed Costs
  • State Premium taxes
  • Advertising/Commissions
  • 20% -30% of premium
77
Q

Exposure Unit

A
  • things expected to loss
  • cars, drivers, building, person’s life
  • P* o single Unit
  • P* on a group of similar units
78
Q

Probability

A
  • Measures the likelihood of an event
  • Ranges from 0 - 1
  • If P = 1, certain
  • If P = 0, Impossible
79
Q

Mutually Exclusive

A
  • Cannot occur at the same time

- Individual probabilities must equal 1

80
Q

Random Variable

A
  • Outcome depends on some chance event
  • The results are random
  • Rolling dice; Coin Flip
81
Q

Random Variables in RM

A
  • Frequency
  • Severity
  • Total $ losses in a given time period: depend on frequency and severity
82
Q

Frequency

A

Total # of losses in a given time period

83
Q

Severity

A

Dollar value of losses that do occur (severity)

84
Q

Probability Distribution

A
  • Graph or table which indicates for each outcome of a random event, the probability of that occurring
  • Uniform distribution
  • Bell Curve
85
Q

Measure of Central Tendency

A
  • Mean = Average = Expected Value = P*
  • Median = Midpoint
  • Mode = Outcome that occurs most frequently
86
Q

Measure of Dispersion

A
  • Variance, Standard Deviation, and Coefficient of Variation

- Greater Dispersion (Variance, S.D., Coeff) = greater risk

87
Q

Law of Large Numbers

A
  • Over time the more data you collect ore more observations that occur the more accurate the estimate
88
Q

Trying to Estimate P* - Expected Loss

A
  1. First determine frequency of loss: calculate # of losses
  2. Second determine severity of loss: calculate loss amounts
  3. Measure total loss exposure: ultimate question, how much will it cost?
89
Q

Frequency

A
  • To figure of frequency = F
  • Can use two different measures
    1. Total # of accidents/Total # of Drivers
    2.
90
Q

Severity

A
  • First assume severity not random

- when losses

91
Q

Priori Probability

A
  • Can be deduced in advance: coin flip, dice

- Assumption: All possible outcomes are known, all outcomes equally likely, all outcomes mutually exclusive

92
Q

Statistical Probability

A
  • Make estimates based on statistics

- Run an experiment and use results from collected data

93
Q

Maximum Probable Loss

A
  • Largest loss most likely to occur

- Not always an exact answer - key is how you present it

94
Q

Risk Management Alternates

A
  • Evaluate Alternatives to managing the risks you or your firm faces
  • Step 3 in RM process
95
Q

Risk Control Options

A
  • Activities or attempts to control the risks
  • Reduce frequency of the loss
  • Reduce the severity of the loss
  • Improve predictability of loss
  • Less Variable: objective risk falls as result, decrease in coefficient in variation
96
Q

Avoidance

A
  • Stop engaging in activity that causes loss
  • Or never engage in activity that causes loss
  • Risk reduced to zero if properly implemented
97
Q

Problems With Avoidance

A
  • Some can’t be avoided
  • May not be feasible or desirable
  • Opportunity Cost - lose profits associated with activity
  • Legacy Cost; may avoid future losses by avoidance, might not avoid costs from past
  • Trade one risk for another
98
Q

When Is Avoidance a Good Strategy

A
  • Usually high frequency, high severity claims
  • Conduct cost benefit analysis
  • When costs of risk is greater than benefit (profit)
  • Avoidance is mutually exclusive with respect to all other options
99
Q

Loss Prevention

A
  • Attempts to reduce the frequency or probability of the loss
  • Does not completely eliminate it
  • Activities that attempt to intercept or break the chain of events that lead to loss
  • Take place prior to loss
  • Training program, safety inspections, quality control
100
Q

Loss Reduction

A
  • Assume Loss will occur
  • What can be done prior to or after
  • Reduce severity
  • Pre loss, loss reduction activities: exit signs, sprinkler system, fire drill
  • Post Loss - loss reduction activities: salvage operations, legal defenses, crisis management, rehabilitation of injured worker
101
Q

Separation of Exposure Units

A
  • Break Items or activities or assets of responsibilities down into smaller parts and separate them
  • One delivery truck vs. 2
  • Limits size of loss from any one occurrence
  • Works well to reduce net income loss exposures
  • Impact of lowering the coefficient of variation
  • Cost may be in terms of the cost of multiple exposure units and the losses to these multiple units
102
Q

Duplication of Exposure Units

A
  • Key asset or activity is replicated and held in reserve
  • Spare parts, back up disks, copies of record
  • Critical that replicates kept in reserve
  • Do not use
103
Q

Risk Transfer Control Type

A
  • Shift the activity or asset exposed to loss to a third party
  • Also shifts the loss; sale of a building, sell a dangerous product line
  • Loss exposure cannot come back to you
104
Q

Risk Financing Options

A
  • Deals with sources of funds to pay for these losses

- External or Internal Funds

105
Q

Risk Transfers of the Financing Type

A
  • See external sources from 3rd parties to finance losses
  • Still have asset or activity exposed to loss
  • Transfer the financial responsibility for the loss, not the asset or activity itself
  • Insurance
106
Q

Insurance

A
  • Transfer the financial responsibility of the loss to the insurer
  • But not the asset or activity itself
107
Q

Non-Insurance Risk Transfers

A
  • Leases
  • Hold Harmless Agreement
  • Retention
108
Q

Leases

A
  • Tenant is responsible for all property losses while occupying the property
  • If tenant fails, then the owner is ultimately responsible
109
Q

Hold Harmless Agreement

A
  • Someone contractually accepts risk for you
  • Contractor doing job, vendor performing a task, company promises a firm doing work for them that they accept all responsibilities
110
Q

Retentino

A
  • A firm or individual engaging in retention assumes the financial responsibility for losses that do occur
  • Retain the exposure to loss; not buying insurance, insurance with deductible
111
Q

Funded Retention

A
  • A firm sets aside funds every period to pay for losses

- Better for losses that are predictable and high in severity

112
Q

Unfunded

A
  • No separate fund to pay for losses
  • Pay for losses as they occur from money you borrow
  • Better for losses that are low frequency and low in severity
113
Q

Active Retention

A
  • Deliberate decision to practice retention
114
Q

Passive Retention

A
  • Retaining the exposure to loss, but you may be unaware

- Usually results from failure to identify

115
Q

Self Insurance

A
  • Planned and Funded Retention
  • Usually for significant loss exposures where many exposure units exist
  • Formal Program, not just something that happens, well thought out strategy
  • Fairly Predictable: Medical Plan for Employees
  • Long pay out period: worker’s compensation
116
Q

Self Insurance Advantages

A
  • Flexibility - most contracts are very standardized, avoid state mandated benefit laws
  • No Loading - No premium taxes, no administrative expenses, no marketing expenses, Premium = P* risk charge + loading
  • Money - any credits are invested internally - which would probably produce higher rate; saving from any loss prevention/reduction goes directly into your pocket instead of insurance company
117
Q

Self Insurance Disadvantages

A
  • Catastrophic Loss Possibility
  • Firm may have to perform administration functions
  • Can be PR nightmare
  • Hard to return to insurance market once you have left
  • Income Tax Treatment
118
Q

Self Insurance Disadvantages/ Catastrophic Loss Possibility

A
  • One large loss could wipe you out
  • can handle with stop loss insurance - but you must pay premium
  • insurance contract with very large deductible - stop loss
  • Aggregate is a total amount limits
119
Q

Self Insurance Disadvantages/Firm may have to perform administration functions

A
  • Claims settlement, return to work programs, wellness programs, etc
  • Only solve with ASO (Administrative Services Only) contract with insurer
  • Can hire a TPA (Third Party Administrator) to handle those finances
  • Again, ASO + TPO services cost money
120
Q

Self Insurance Disadvantages/Can Be PR Nightmare

A
  • Could give the impression that the company is financially unstable
  • Can’t pass the blame to the insurer when denying claims
  • Hard to return to insurance market once you have left (High Risk)
121
Q

Self Insurance Disadvantages/Income Tax Treatment

A
  • Insurance; premiums are tax deductible in tax year when they are paid
  • Cost of doing business = premium
  • Premium represents cost of losses that have yet to occur
  • Allows firm to pre-deduct cost of future losses
122
Q

Captives + Risk Retention Groups

A
  • Hard Market’s occur (Post 9/11-terrorism) where cost of insurance rises tremendously
  • Certain coverage have increasing costs (Current medical mal practice)
  • Captives and RRG formed to handle
  • Captives and RRG also help the income tax issue with self funding
123
Q

Captive Insurer

A
  • Insurance Company is wholly owned subsidiary of company (parent is not in the insurance business)
  • Primary purpose is to insure the risks of the parent or parents (If more than one company)
  • Could be similar companies, an association of municipalities, possibilities are limitless
124
Q

Two Types of Captive Insurer

A
  • Single Parent

- Association Captive with more than one parent

125
Q

Captive Insurer Advantages

A
  • Helps during hard markets
  • Often located in Bermuda or Cayman Islands giving regulatory and income tax advantages
  • Tax treatment in US; can write of premium if it is a true risk transfer,
  • True Risk Transfer = parent risk makes up no more than 30% of the risk portfolios

Intro To Risk Management (10 decks)

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