Risk Management Flashcards

1
Q

Describe the relationship of peril and hazard to risk.

A

Risk, peril and hazard are interrelated concepts. Risk is defined as uncertainty concerning the possibility of a loss. A peril basically is the cause of a loss. Such things as fires, floods, theft, illness and death are perils. A hazard is a condition that increases the probability that a peril will occur or tends to increase the severity of the loss when a peril occurs.

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2
Q

What is a physical hazard?

A

A physical hazard is a physical condition, such as defective wiring in a building or the absence of fire-extinguishing equipment, that increases the chances of loss.

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3
Q

What is a moral hazard?

A

A moral hazard exists when dishonesty or other character defects in an individual increase the chances of loss. A classic example of a moral hazard is arson. Because of moral hazards, premiums are higher to all insureds including the honest insureds.

Insurers attempt to control moral hazard by careful underwriting and by various policy provisions such as deductibles, waiting periods, exclusions and riders.

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4
Q

What is morale hazard?

A

Morale hazard consists of carelessness or indifference that individuals have because they are covered by insurance and thereby protected against loss. An important problem in the benefits area that can be considered a morale hazard is employees or medical providers scheduling unneeded medical tests or medications.

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5
Q

What is pure risk?

A

Pure risks involve situations where only two alternatives are possible - either the risk will not happen (no financial loss) or it will happen and a financial loss takes place. For example, the risks of fire, auto accidents, illness, unemployment, disability, theft of property and earthquake are all pure risks.

Many employee benefit coverages fall into this classification. It should be noted that nothing positive can result from a pure risk. Illness can be used as an illustration of pure risk. The best thing that can happen is for one not to become ill because if one does become ill, a negative result takes place. It should be noted that many pure risks can be insured.

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6
Q

What is speculative risk?

A

Speculative risks involve situations where a possibility that does not exist in a pure risk is present, namely, the possibility of a gain. Thus, speculative risks have three potential outcomes: (1) a loss (2) no loss and (3) a gain. Some examples of speculative risks are the purchase of a share of common stock, acquiring a new business venture or gambling.

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7
Q

From an employee benefit perspective, what is the most important type of pure risk to cover. Explain.

A

The most important classification of pure risk from an employee benefit standpoint is personal risk. Personal risks are losses that directly impact an individual’s life or health. Many risks involving employee benefit plans fall into this classification. Death, illness, disability, unemployment and old age are all personal risks.

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8
Q

What are property risks?

A

Property risks involve potential losses to the value of one’s real or personal property. Fire, flood, earthquake, wind, theft and auto collisions are examples of potential sources of property risks; and a dwelling house, furniture, auto and jewelry are examples of types of potential property subject to loss.

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9
Q

What are legal liability risks?

A

Legal liability risks involve losses resulting from the negligent or wrongful actions of individuals that result in injuries or losses to others. They stem from lawsuits by the injured people seeking damages from negligent parties. Some common sources of legal liability are negligent behavior associated with the ownership and use of automobiles, the operations of one’s home or business, the manufacture and/or sale of products, the performance of one’s job and professional misconduct.

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10
Q

Do employee benefit plans cover property and legal liability risks? Explain why or why not.

A

Property and legal liability risk coverages can be found in a number of employee benefit plans. For example, homeowners insurance, auto insurance and group legal services plans all involve property and liability risk coverages. Nevertheless, there is a much greater emphasis on personal risk in employee benefit plans.

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11
Q

Briefly summarize the methods that can be used for handling risk.

A

(a) Avoidance - one does not acquire or take on the risk to begin with or gets rid of the risk and therefore is not subject to the risk. You can avoid the risk of breaking a leg while skiing by not skiing.
(b) Control - a mechanism by which one attempts either to prevent or reduce the probability of a loss taking place or to reduce the severity of the loss if it does take place. You can reduce the risk of having a heart attack by giving up smoking.
(c) Retention - the risk is assumed and paid for by the person suffering the loss or taking responsibility for the loss. You can retain the risk of small automobile collision loss by buying a car insurance policy with a $500 or higher deductible.
(d) Transfer - one switches or shifts the financial burden of risk to another party.
(e) Insurance - a form of transfer in which the financial burden of a risk is transferred to an insurance company.

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12
Q

Need to Know - Review Answer

A

From the standpoint of an employee benefit plan, insurance is a mechanism in which the insured (employer/employee) pays money (premiums) into a fund (insurance company). Upon the occurrence of a loss, reimbursement is provided to the person suffering the loss. Thus, the risk has been reduced or eliminated for the insured; and all the individuals who paid into the fund share the resulting loss.

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13
Q

Compare the insurance mechanism with gambling.

A

Insurance is a mechanism for handling an existing risk, whereas gambling creates a risk where one did not previously exist.

The risk created by gambling is a speculative risk, whereas insurance deals with pure risks.

Gambling involves a gain for one party, the winner, at the expense of the other, the loser, whereas insurance is based on mutual sharing of any losses that occur.

The loser in a gambling transaction remains in the negative situation, whereas an insured who suffers a loss is financially restored in whole or in part to his or her original situation.

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14
Q

Explain the principle of indemnification:

A

The fact that insurance is used to make the victims of losses whole reflects the principle of indemnification on which insurance is structured. An insured is indemnified if a covered loss occurs. That is, he or she is placed in somewhat the same situation that existed prior to the loss, for example, reimbursement for damaged property, medical bills, disability income and the like.

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15
Q

Which risk-handling alternative is the only one that is mutually exclusive of the others? Why?

A

Avoidance. When you avoid a risk, you have no losses, so there is no need for other risk-handling techniques.

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16
Q

Need to know - Review answer.

A

The concept of risk is important in employee benefit planning. Risk in this context means uncertainty with respect to possible losses. It refers to the inability to determine with definiteness (certainty) the actual number and value of the claims that a benefit plan will have to meet.

17
Q

What are the advantages of using insurance to fund an employee benefit plan?

A

(a) Known Premium - The presence of a known premium (cost) that is set in advance by the insurance company can be an advantage to the employer. The employer may have better control over the budget with the known premium because any high levels of losses would be the problem of the insurance company and not the employer.
(b) Outside Administration - Having an outside administrator can also be an advantage to the employer. The employer does not have to get involved in disputes involving the employees over coverage of the plan since these matters are handled by the insurance company.
(c) Financial Backing - Employees may prefer insurance to some other form of funding to obtain the financial backing of an outside financial institution. This, of course, depends upon the financial strength of the insurance company selected, and care should go into the process.
(d) Cost Management - Insurance companies often are leaders in the area of loss control and thus frequently can help in designing and implementing systems established to limit employee benefit cost for an employer.
(e) Economy - It may be more economical for an employer to use insurance than other alternatives. An insurance company may be able to do the job more efficiently and at a lower total cost than other alternatives.

18
Q

What are the disadvantages of using insurance to fund an employee benefit plan?

A

(a) Possible Additional Costs - A number of costs must be considered. Administrative expenses are charged by insurance companies. Premiums include a charge or “loading” that compensates for their overhead expenses. Home office costs, licensing costs, commissions, taxes, loss adjustment expense, and the like, are all included in the loading. Thus, the premiums covers not only direct losses but these overhead costs, too. The amount may vary from a small percentage of the premium (2-5%) to potentially a quite high amount (25% or more) depending upon the type of contract involved.
(b) Employee Satisfaction - Employee satisfaction is directly affected by the claims and problem-solving abilities of the insurer. Slow payment or restrictive claim practices can have an adverse effect on employees. (Employer satisfaction with an insurer’s services is directly linked to employee satisfaction).

19
Q

What are the six requirements of an ideal insurable risk from the standpoint of an insurance company?

A

(1) There must be a large number of homogenous risks (exposure units). This is to enable the insurer to predict loss based on the law of large numbers.
(2) The loss should be both verifiable and measurable. This means the loss must be definite as to cause, time, place and amount. The insurer must be able to determine if the loss is covered under the policy and, if it is, how much the company will pay.
(3) The loss should not be catastrophic in nature. This means that a large number of exposure units should not suffer losses it at the same time, or else the pooling becomes unworkable.
(4) The chance of loss should be subject to calculation. The insurer must be able to ascertain both the average frequency and the average severity of future losses with some accuracy. This will facilitate the development of an adequate premium, one that is sufficient to pay all claims and expenses and that yields a profit during the policy period.
(5) The premium should be reasonable or economically feasible. Specifically, the insured must be able to afford the premium, and the premium should be substantially less than the face value or amount of the policy.
(6) The loss should be accidental and unintentional from the standpoint of the insured. Ideally, it should be outside the insured’s control. If an individual deliberately causes a loss, it should not be paid. This requirement decreases the moral hazard and facilitates the working of the law of large numbers. The push toward “consumer-directed” health plans is partially an attempt to encourage employees to be more selective and aware of the importance of cost control in the selection and use of medical services.

20
Q

What is the law of large numbers?

A

Insurance is based on the law of large numbers, which means that the greater the number of exposures, the more closely the actual results will approach the probable results that are expected from an infinite number of exposures.

21
Q

How do employee benefit plans generally handle the possibility of catastrophic losses?

A

Employee benefit plans often insure life risks, hospital and dental risks, and disability income losses. Usually, these are not subject to catastrophic occurrences because of geographic location, but catastrophic losses can take place, such as a plant explosion, a poisonous gas leak causing a large number of deaths or injuries, or a concentration of certain diseases because of the exposure to certain elements that are indigenous to a specific employee group. However, this usually is not an important consideration in underwriting typical benefit plans. Policy limitations, reinsurance and restrictions on groups insured all can be used to minimize the problem to the extent it exists.

22
Q

What is adverse selection?

A

Adverse selection exists when individuals who have higher-than-average risks join a group or comprise a larger percentage of a group than anticipated, because of the availability of insurance or other benefits. In that case, they are said to “select against” the insurer.

23
Q

What are the underwriting methods used by insurers to address the problem of adverse selection by individual applicants for insurance coverage?

A

That desirable situation for an insurance company is to have a spread of risks throughout a range of acceptable insureds. The so-called spread ideally will include some risks that are higher and some that are lower than the average risk within the range. Insurers attempt to control adverse selection by the use of sophisticated underwriting methods and supportive policy provisions. Underwriting is the uniform process by which insurers select and classify applicants for insurance. Examples of the types of policy provisions used to control adverse include pre-existing conditions clauses in medical expense policies, suicide clauses, maximum coverage amounts and open enrollment period restrictions?

24
Q

How does the group insurance underwriting technique used an employee benefit plans allow the problem of adverse selection to be dealt with differently from the way it is handled under individual insurance?

A

The management of adverse selection under group insurance contracts necessarily is different from the approach used an individual insurance. Group insurance is based on the group as a unit and, typically, individual insurance eligibility requirements are not used for the group Insurance underwriting used in employee benefit plans. As an alternative, the group technique itself is used to control the problem of adverse selection.

25
Q

What are the characteristics of the group technique that enable such coverages as life and health insurance to be written as employee benefit plans by minimizing the risk of adverse selection?

A

(A) Only certain groups are eligible. A group should not be formed solely for the purpose of obtaining insurance. The purpose of obtaining insurance should be incidental to the formation of the group.

(B) There should be a steady flow of lives through the group. Younger individuals should come into the group as older individuals leave it to maintain a fairly constant mortality or morbidity ratio in the group.

(C) There should be a minimum number of persons in the group. This is meant to prevent unhealthy individuals from being a major part of the group and to spread the expenses of the benefit plan over a larger number of individuals.

(D) A minimum portion of the group must participate. The rationale for this provision, too, is to reduce the possibility of adverse selection and to spread the expense of administration of the plan.

(E) Frequently, eligibility requirements are imposed under group plans for the purpose, once again, of preventing adverse selection.

(F) Maximum limits on the amount of benefits may be imposed to prevent the possibility of an excessive amount of coverage on any particular unhealthy individual.

(G) To prevent unhealthy lives in a group from obtaining an extremely large amount of a particular benefit, there is automatic to determination of benefits whereby coverage is determined for all individuals in the group on an automatic basis.

26
Q

Need to Know - Review Answer

A

Over the years, many of the requirements of the group technique has been liberalized as providers of employee benefits have gained experience in handling group employee benefits and because of the competitive environment. Nevertheless, the basic group selection technique is important in understanding why employee benefits can work on a group basis and how any problems that exist might be corrected.

27
Q

What distinguishes self-funding from the insurance method of financing employee benefit plans?

A

Self-funding or self-insurance of employee benefit plans means that an organization retains the risks as opposed to an insurance company taking on the risks in return for premium. For self-funding, the key characteristic of an ideally insurable risk that must be present is that the organization be big enough to permit the combination of a sufficiently large number of exposure units to make losses predictable. That is, the program must be based on the operation of the law of large numbers.

Obviously, if you organizations are large enough to engage in that sound program that meets requirements of an ideally insurable risk without some arrangement with an insurer. Indeed, many so-called self-funded employee benefit plans transfer some of the pure risks undertaken to an insurer in whole or in part.

28
Q

What is a situation that will either result in a financial loss if it occurs or no financial loss if it does not occur?

A

Pure risk.

29
Q

Which of the following is (are) among the basic traditional characteristics of the insurance mechanism?

I. Transfer o a speculative risk to the insurer.
II. Pooling or sharing of losses.
III. Indemnification, in whole or part, of the victim of a loss.

A

II and III only

30
Q

All the following are characteristics of the group technique that enables such coverages as life and health insurance to be written as employee benefit plans by minimizing the risk of adverse selection EXCEPT:

A. Only certain groups are eligible.
B. A steady flow of the lives through the group.
C. Individual determination of benefits.
D. A minimum portion of the group must participate.
E. Eligibility requirements.

A

C. Individual determination of benefits.