FIN 3305 Exam 1 Flashcards
1
Q
Definition of Risk
A
Uncertainty about economic loss
2
Q
What are the consequences of risk?
A
Risk creates additional costs for businesses, government, and individuals
- Losses (when they occur)
- Higher borrowing costs
- Greater liquidity needs
- Opportunity costs
3
Q
Cost of Risk
A
Cost to finance potential losses + cost of unreimbursed losses + outlays to reduce risk + opportunity cost of forgone activities
4
Q
What are the 4 Categories of Risk?
A
- Pure vs. Speculative Risk
- Fundamental vs. Particular Risk
- Static vs. Dynamic Risk
- Subjective vs. Objective Risk
5
Q
Pure Risk
A
2 Possible outcomes: loss or nothing
(ex. fire, theft, flood)
6
Q
Speculative Risk
A
3 Possible Outcomes: Loss, nothing, or GAIN
(ex. investing, gambling, entrepreneurship)
7
Q
Fundamental Risk
A
Impacts a large number of people or companies
(ex. Hurricanes, inflation, pandemics)
**Losses are correlated
8
Q
Particular Risk
A
Impacts only one or a few people or companies
(ex. auto accidents, burglaries, lightning strikes)
**Losses are uncorrelated
9
Q
What is one important thing to note about fundamental vs. particular risk? (category 2)
A
Unlike pure vs speculative, this is a continuum … some risks impact a medium number of people and could be categorized as either
10
Q
Static Risk
A
Risk in an unchanging environment
(ex. lightning, windstorms, death)
**These risks look similar from each year to the next
11
Q
Dynamic Risk
A
Risk created by changes in society
(cyber attacks, regulatory/tax compliance, oil prices)
**These risks look quite different each year
12
Q
Subjective Risk
A
Risk based on the mental state of an individual; Stems from doubt or worry about outcomes; Psychological uncertainty (ex. fear of airplane travel)
13
Q
Objective Risk
A
The probable variation of actual from expected experience; Precisely observable and thus measurable
(ex. outcome of a dice roll)
14
Q
Property Risk
A
- The risk that property may be damaged, destroyed, or stolen
- Property includes real property (land, buildings, and the things attached to them) and personal property (items that can be moved, such as inventory and vehicles)
- Property losses that happen to others can have domino effects - a fire at a supplier can cause interruptions and shortages for others in the supply chain.
15
Q
Liability Risk
A
- The risk of being held financially liable for “damages” to another party (ex. bodily injury, property damage, breach of contract, regulatory noncompliance)
- Stems from judicial and regulatory systems
- Damages include judgements, settlements, legal fees, and fines
16
Q
Life, Health, and Loss of Income Risk
A
- The risk that a person loses their ability to generate income
- Can be caused by death, injury/illness, retirement, unemployment, etc.
- In addition to loss of income, there may be: funeral costs, medical expenses, additional education/training/travel
17
Q
Financial Risk
A
The risk created by fluctuations in financial markets and economies (ex. credit risk, commodity prices, foreign exchange rates, investment returns, interest rates)
18
Q
Peril
A
A cause of a loss
19
Q
Hazard
A
Conditions that increase the cause of loss
20
Q
Loss
A
Injury or damage sustained by an insured
21
Q
Identify the Peril, Hazard, and Loss in this scenario
“Rashid wrecked his car in the rain yesterday, resulting in a dented fender and crumpled hood”
A
Peril - wrecked his car
Hazard - in the rain
Loss - dented fender and crumpled hood
22
Q
Moral Hazard
A
- An intentional change in behaviors or attitudes caused by the presence of insurance
- People act differently when they have insurance than when they don’t
- Ex. Committing arson to collect insurance money on a building
- Can be, but is not necessarily, immoral behavior … How likely are you to go to the doctor for a cold if you don’t have insurance?
23
Q
Morale Hazard
A
- Carelessness or indifference to loss, usually caused by the presence of insurance or other protection from loss
- Ex. Forgetting to lock your front door, distracted driving, building in a flood zone
24
Q
Moral Hazard vs. Morale Hazard
How does this relate to “Adverse Selection”?
A
- Insurance traditionally distinguishes between these two, economics does not
- Closely related to “adverse selection” - the tendency of a higher-than-average risk to seek insurance coverage at the rate for an average risk
- Both are issues of asymmetric information - the insured knows more of their own behavior and motives than the insurer
25
Risk Management
* The process used to systematically manage risk exposures
* Traditionally referred to management of PURE RISKS only
26
Risk Manager
A person responsible for minimizing the adverse impact of losses on the achievement of a company's goals
27
Enterprise Risk Management (ERM)
(also known as "integrated risk management")
* A modern and expanded risk management approach which targets all forms of risk
* Management of BOTH pure and speculative risks
*Also known as integrated risk management
28
Chief Risk Officer (CRO)
A risk manager responsible for coordinating and executing a company's ERM strategy
29
Risk Management Process
1. Identify risks
2. Quantify risks (frequency and severity)
3. Evaluate
4. Model - risk map
5. Manage
30
How is financial statement analysis important in the risk management process?
* Review of a firm's balance sheet and income statement
* Helpful to identify risks associated with: asset values, market risks, and business interruption
* Also useful to review strategic plans, budgets, forecasts, etc.
31
Loss Exposure Checklists
(way of identifying risk)
* Lists of potential sources of loss
- Audits
- Customer complaints
- Industry trends
- Current Events
- New or pending legislation or regulation
* "Is this a potential source of loss to me or my firm?"
* Focuses primarily on property and liability exposure
* Some lists are designed for specific industries (ex. education)
* Some lists focus on specific risk categories (ex. property)
32
Loss Exposure
A potential loss that may be associated with a specific type of risk
33
Analysis of Past Losses
(way of identifying risk)
* Review loss history (lawsuits, regulatory fines, significant financial losses)
* Conduct statistical analysis
34
Risk Management Information System (RMIS)
* Software to track past losses and their characteristics
* Increasingly sophisticated and user-friendly
* Trend toward web-based access
35
Flowcharts
(way of identifying risk)
* Graphical representation of a firm's inputs, processes, and outputs
* "What events could disrupt the even and uninterrupted flow of parts to the final assembly floor, on which the whole production process depends?"
* Helpful to identify risks associated with: supply chains, interdependencies between two processes, Potential bottlenecks and domino effects
*Pay special attention to new products, procedures, personnel
36
Contract Analysis
(way of identifying risk)
* Review of the firm's contracts with other parties
* Helps to identify
1. New risks from other parties
2. Whether the firm is effectively transferring risk to
other parties
37
Contractual Liability
Liability arising from contractual agreements, which state that some losses (if they occur) are to be borne by specific parties
38
On-site inspections
(way of identifying risk)
* Physical inspection of property
* May include interviews/discussions with on-site employees
* Helps to identify both property and liability risk (and hazards)
* Can be done by internal parties (risk manager) or external parties (consultant)
39
Risk Maps
(way of evaluating risk)
* A matrix of all major risks the firm faces
* Plots frequency against severity
* May also denote risk type, risk management activities, etc.
* Helps to prioritize risks and allocate risk management resources
40
Frequency
(way of evaluating risk)
* The long-term probability of an event's occurrence (aka chance/likelihood)
* ranges from 0 (impossible) to 1 (certain)
41
Probability Distribution
Mutually exclusive and exhaustive list of possible events and their probabilities
42
Law of Large Numbers (LLN)
* As the number of exposure units increases, the more likely that actual loss experience will equal probable loss experience
* In other words ... if you have more data, your predictions will be more accurate
43
How many exposure units are needed? (LLN formula)
S = number of standard deviations in the distribution
p = probability of loss
E = degree of accuracy required
44
Chance of Loss
* The probability that a specific loss occurs in a particular period of time
45
Expected Loss
The average loss amount, adjusting for loss probability
46
Degree of Risk
* The amount of objective risk present in a situation
* The difference between actual losses and expected losses
* Actual losses involve a range of outcomes
* Captures variation around expected loss
(only meaningful for uncertain events ... definite or impossible events do not involve risk)
47
Measuring Degree of Risk (calculation)
48
Risk Evaluation
Estimate frequency and severity of potential losses
49
Inherent Risk
Risk before any risk management implemented
50
Residual Risk
Risk remaining after risk management has been implemented
51
Common Measures of Risk
Frequency and Severity
52
Frequency
The number of losses during a specified period
53
Severity
The average magnitude of loss (usually $ value) per claim
54
Mean
Sum of measurements divided by number of measurements (average)
55
Median
The midpoint in a range of measurements
56
Mode
The value that occurs most often in a frequency distribution
57
Is severity a continuum?
Yes, severity is a continuum - assets may not be completely destroyed
58
Maximum Probable Loss
The likely amount of loss that might result
59
Maximum Possible Loss
The worst amount of loss that could result
60
Historical Method of Valuing Risk
Measuring actual gains or losses over a period of time
61
Probability
The long-term frequency of an event's occurrence (aka likelihood); Ranges from 0 to 1
62
Expected Value or Expected Loss
Uses weighted averages based on the probability of certain events; Some events are more likely than others
63
Common Measures of Risk
Variance and Standard Deviation
64
How are Variance and Standard Deviation related?
Square root of variance = standard deviation
65
Coefficient of Variation
* The standard deviation of a distribution divided by its mean
* It compares risk (measured by the standard deviation) to the expected result (mean)
* It is especially useful to indicate a relative value of risk when the means of the distributions are not equal
66
The Normal Distribution
* Aka the "bell curve"
* ~68% of observations are within 1 standard deviation of the mean
* ~95% of observations are within 2 standard deviations of the mean
* ~99% of observations are within 3 standard deviations of the mean
67
How is the normal distribution useful in risk management?
* Useful in measurement of natural phenomena
* Often used for systemic risks such as currency exchange risk, inflation, and interest rates
* Can measure infinite outcomes (ex. different levels of $ losses per occurrence)
68
The Binomial Distribution
* Measures number of outcomes in a fixed number of trials
* Probability of an event is p
* Probability of an event NOT happening is q = p-1
* There are n possible times the event could happen
* The probability that the event happens r times
69
Requirements for a Binomial Distribution
1. Must have a fixed number of occurrences in view
2. Outcomes measured must be binary
70
The Poisson Distribution
* Models the number of events occurring in a fixed interval of time or space
* Event occurs with probability p
* Mean loss frequency is m
* The probability that the event happens r times
(e is the constant 2.72)
71
What is a requirement of the Poisson Distribution and how is it useful?
* Outcomes measured must be binary
* Useful in predicting the number of events over a specific time
* Useful for measuring relatively rare and independent events
72
Value at Risk (VAR)
* The maximum amount exposed to loss with a specified degree of likelihood
* Holistic measure that captures correlation between risks
73
Risk-Adjusted Return on Capital (RAROC)
The capital required to keep the probability of bankruptcy below a specified level, given the risk posed by the organization's activities
74
Real Property
(Category of Loss Exposure)
Land and all structures permanently attached to land (buildings, fixtures, crops)
75
Personal Property
(Category of Loss Exposure)
All other property (not permanently attached to real property); Vehicles, contents
76
Liability
(Category of Loss Exposure)
Amount owed to reimburse another for injury caused by you or your personal property or occurring on your real property
77
Direct Loss
(Types of Loss)
A loss that stems directly from an unbroken chain of events leading from a peril to a loss (ex. fire damage, theft, bodily injury)
78
Indirect Loss
(Types of Loss)
A loss that occurs as the consequence of a direct loss (business interruption, renting alternative space, loss of income)
79
Bodily Injury
(Types of Liability Damages)
Damages to a person's body or mind (medical bills, loss of income, rehabilitation costs, pain and suffering, punitive damages)
80
Property
(Types of Liability Damages)
Property damage to property of another; Includes indirect damages such as loss of use
81
Legal Expenses
(Types of Liability Damages)
Legal expenses to defend; Most liability insurance includes coverage for defense costs
82
Criminal Law
* Wrongs against society (murder, robbery, rape, assault, etc)
* Charges made by government body or agent
* Punishable by fine and/or imprisonment
* Limited risk management options, not insurable
83
Civil Law
* Wrongs against individuals or organizations (breach of contract, negligence, etc)
* Lawsuit filed by injured party
* Punishable by paying damages, fines, require change in action
* Primary focus on liability risk management
84
Can one action result in both criminal and civil charges?
Yes
85
Torts
* A legal injury or wrong to another that arises out of actions other than breach of contract
* Civil action
* Negligence is primary focus
* Torts also include intentional torts, such as libel, slander, trespass, and assault
86
Negligence
* The failure to exercise the degree of care required by law
* Injured party (plaintiff) must prove 4 elements
87
What must the plaintiff prove in negligence cases?
1. Legal duty owed (reasonable care)
2. Breach of legal duty
3. Damages (usually bodily injury or property damage)
4. Proximate cause of loss
88
Does negligent action have to be voluntary and intentional?
Negligent action must be voluntary, does not have to be intentional
89
Vicarious Liability
Imputed acts may transfer liability to another (ex. employer may be held liable for employee's negligence)
90
Contributory Negligence
(Defenses to Negligence)
If plaintiff contributed to their own injury, they may not recover any damages (only in some states)
91
Comparative Negligence
(Defenses to Negligence)
If plaintiff contributed to their own injury, damages are allocated based on percentage of fault
92
Assumed Risk
(Defenses to Negligence)
Plaintiff assumed that there was risk of harm from:
1. Conduct of the defendant
2. Condition of the premises
3. The defendant's product
93
Guest-Host Statutes
(Defenses to Negligence)
State laws that lower the standard of care an automobile driver owes to their passengers
94
Factors Leading to Higher Standards of Care
* Expanding application of liability
* Weakening of defenses against liability
* Changing concepts of damage
* Increased damage awards
95
Res ipsa loquitur
"the thing speaks for itself"
Plaintiff may collect without proving negligence in some circumstances
96
Joint and Several Liability
* Expansion of imputed (vicarious) liability
* If several different parties are negligent, larger parties may pay more than their share of damages
97
Employer-Employee Liability
Employers owe the following duties to their employees:
* Provide a safe place to work
* Employ people reasonably competent to carry out tasks
* Warn of danger
* Furnish appropriate and safe tools
* Set up and enforce proper rules of conduct as they relate to safe working procedures
98
What laws do employee injuries usually fall under?
Employe injuries usually fall under workers' compensation liability laws, but there are some exceptions
99
Property Owner-Tenant Liability
* Owner or tenant of real property has a duty of care to those who enter
- Highest degree of care for invitees (customers, guests)
- Lower degree of care for licensees, who are on the
premise with permission (police officers, firefighters,
delivery drivers)
- No degree of care owed to trespassers (but cannot
deliberately injure)
* Tenant usually takes on duty of care from landlord in the lease contract
100
Attractive Nuisance Doctrine
A higher degree of care is owed to children when property contains items that may attract them (ex. swimming pool)
101
Liability with the Consumption or Use of Products
* Sellers (including manufacturers) have a duty to ensure their products are safe
* Goods must be reasonably fit for their intended purpose
* Breaching this duty may be grounds for negligence
* Dangerously defective products may fall under "strict liability", which has a lower burden of proof than negligence
102
Liability with the Ownership and Operation of Automobiles
* Operator of vehicle may be liable for bodily injury or property damage in an accident
* Employers may be vicariously liable for negligent drivin by their employees in the course of their work
* Owners are typically not held negligent if someone else drives their vehicle (primary exception: head of a household may be responsible for family members driving their vehicle, especially minor children)
103
Professional Liability
* Liability arising from errors of a professional in the performance of his/her duties
* Medical malpractice is probably the most well-known
* Also accountants, lawyers, insurance agents, architects, etc.
104
Contractual Liability
Liability created or transferred by the terms of a contract
105
Completed Operations of a Contractor
Liability arising from errors in construction or installation after the work has been completed
106
Principal-Agent Liability
Principals (those directing work) may be legally liable for the actions of their agents (those conducting the work)
107
Risk Avoidance
(Risk Mgt. Techniques - Non Insurance)
* A conscious decision not to expose oneself or one's firm to a particular risk of loss
* Consequences: sometimes results in assuming more risk, inefficiencies, loss of opportunity
108
Loss Control
(Risk Mgt. Techniques - Non Insurance)
* Actions to reduce the frequency and/or severity of losses
* Conscious decisions about how activities are conducted
109
Loss Prevention
Actions to reduce the FREQUENCY of loss
(ex. security measures, training, and process)
110
Loss Reduction
Actions to reduce the SEVERITY of loss
(sprinklers, crash barriers)
Separation - Dispersal of activities (includes diversification)
Duplication - Redundant systems
111
When is loss control implemented?
Loss control can be implemented pre-loss, concurrent to loss, or post-loss
112
Can some loss control activities lower both frequency and severity?
Yes, but usually one more than the other
113
Benefits of Loss Control
* Long-Term savings from fewer or smaller losses
* Lower costs for other risk management investments (ex. lower insurance premiums)
* Intangibles such as higher employee morale and positive public relations
114
Costs of Loss Control
* Dollar amounts invested to implement loss control, such as installation and maintenance
* Some costs are not immediately obvious (ex. electricity bills)
* Possible reduction in efficiency or productivity
115
Risk Retention
Paying for losses with available funds
116
Planned Retention
Conscious and deliberate assumption of risk
117
Unplanned Retentions
Implicit assumption of risk, usually because the risk was not identified or was underestimated
118
Funded Retention
A pre-loss arrangement to ensure that money is readily available to pay for losses that occur (high-severity losses)
119
Unfunded Retention
Absorbing the expense of losses as they occur (low-severity losses)
120
Credit
(Types of Funded Retention)
(ex. Bank loan)
* May be challenging for high-severity risks
* Important to arrange pre-loss
121
Reserve Funds
(Types of Funded Retention)
(ex. savings)
* Good for smaller-severity losses
* Cash holdings are key
122
Self-Insurance
(Types of Funded Retention)
* A form of reserve funding using sophisticated modeling to predict needs
* Need large group of exposure units (to take advantage of the law of large numbers)
123
The Retention Decision
1. Financial Resources
(Does the firm have sufficient funds to pay for losses?)
2. Ability to Predict Loss
(Can loss frequency and severity be predicted)
3. Administrative issues
(Will the firm need to dedicate significant resources to investigating, managing, and paying for losses?)
124
Risk Transfer
Shifting responsibility for payment of a loss to another party
125
Methods of Risk Transfer
1. Insurance - Special contracts involving pooling of risks
2. Incorporation
3. Contracts
4. Capital Market Transactions
126
Incorporation
(Methods of Risk Transfer)
Incorporation creates a "corporate veil" between the assets of the firm and the assets of its owners; Effectively transfer risk to creditors
127
Contracts
(Methods of Risk Transfer)
* Warranty - Manufacturer accepts risk of loss due to repair or replacement for a limited time
* Guaranty - Person exposed to potential loss seeks a third party to pay for any loss
* Allocation of liability for various events can be specifically described in a contract (usually occurs in an "indemnity" or "hold harmless" clause.
128
Hold-Harmless Agreements
Provisions inserted into contracts that transfer responsibility for losses from one party to another
129
Limited Form Hold-Harmless Agreements
Clarifies that all parties are responsible for liabilities arising from their own actions
130
Intermediate form Hold-Harmless Agreements
One party agrees to pay for any losses that both parties are jointly responsible for
131
Broad Form Hold-Harmless Agreements
One party agrees to pay for all losses, regardless of fault
132
Typical Financial Risks
Price changes, interest rate changes, currency exchange rates, liquidity, credit risk, general market conditions
133
What kind of risks are financial risks?
Financial risks are speculative risks (there is a possibility of gain or loss)
134
3 Financial Risk Management Techniques
Diversification, Hedging, Securitization
135
Describe Diversification
* Strategy to reduce unsystematic risk - risk that is unique to a specific investment
* Adding additional assets to portfolio from a different company/source reduces variance and standard deviation of expected results (i.e. reduces risk)
* Tools include mutual funds, REITS, money market funds, reinsurance (for insurers)
136
How are hedging and securitization usually done?
Generally done by using derivatives
137
Derivatives
A financial security whose value is derived from another underlying asset
138
Futures
A contract to buy or sell an asset for a specified price at a specified future time that is standardized and traded on an exchange
139
Forwards
A contract to buy or sell an asset for a specified price at a specified future time that is specific to a customer and traded over the counter
140
Spot Price
The current price for a particular asset on the public market
141
Basis
The difference between spot price and the price of the asset in the futures or forward contract with the closest expiration date
142
Options
* A contract that gives the right to buy or sell an asset for a specified price at a specified future time
* Differs from a forward/futures contract because of OPTION to buy or sell, not an obligation to buy or sell
143
Call Option
The right to buy at a specific price
144
Put Option
The right to sell at a specific price
145
Strike Price
The price that triggers the right to buy or sell - aka exercise price
146
Swaps
Agreement to exchange or transfer variable factors for a fixed contractual price
* Commodity prices
* Interest rates
* Exchange rates
147
Securitization
Process by which illiquid assets are converted into tradable securities
148
Asset-Backed Security (ABS)
Generic term for a tradable security backed by a pool of cash-producing assets
149
Mortgage-Backed Security (MBS)
ABS backed by a pool of mortgages
150
Collateralized Debt Obligation (CDO)
ABS backed by a pool of diversified assets
151
Credit Default Swaps
Derivative providing the security investor a guaranty of income stream should the underlying asset in the derivate fail to provide the expected income stream
152
Catastrophe (Cat) Bonds
* Cat Bonds are a form of securitization
* The risk of catastrophes are transferred from insurers to investors in capital markets
* If insurers suffer large loss from defined catastrophic events, investors in Cat Bonds lose their money
* The insurance risk of the insurance company is traded - by making it a commodity and taking it to the capital markets in addition to or instead of to the insurance/reinsurance market
