Risk Management Flashcards
Describe the relationship of peril and hazard to risk.
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.
What is a physical hazard?
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.
What is a moral hazard?
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.
What is morale hazard?
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.
What is pure risk?
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.
What is speculative risk?
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.
From an employee benefit perspective, what is the most important type of pure risk to cover. Explain.
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.
What are property risks?
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.
What are legal liability risks?
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.
Do employee benefit plans cover property and legal liability risks? Explain why or why not.
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.
Briefly summarize the methods that can be used for handling risk.
(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.
Need to Know - Review Answer
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.
Compare the insurance mechanism with gambling.
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.
Explain the principle of indemnification:
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.
Which risk-handling alternative is the only one that is mutually exclusive of the others? Why?
Avoidance. When you avoid a risk, you have no losses, so there is no need for other risk-handling techniques.