RMIN Exam 1 Flashcards
risk
a calculated possibility of a negative income
calculated possibility
a probabilistic outcome (chance/likelihood of loss) that is known or estimated, ranges from 0-1
highest calculated possibility risk
0.5, most uncertainty, could go either way
negative loss
loss, must be quantifiable
frequency
the number of losses (fire, theft, collision) that occur within a specific time period, probability of loss
severity
the dollar amount of loss for a specific peril (fire, theft, collision)
frequency equation
frequency = number of losses / number of exposures
severity equation
severity = total losses ($) / number of losses
expected loss equation
expected loss = frequency x severity
peril
cause of loss (ex: fire, tornado, collision, burglary)
hazard
condition that creates or increases the frequency and/or severity of a loss, does not cause a loss
physical hazard
a physical condition that increases the frequency and/or severity of a loss
moral hazard
the presence of insurance changes the behavior of the insured (ex: exaggerating the value of insured property, using a hammer to create “hail” damage to a roof)
morale (attitudinal) hazard
carelessness or indifference to a loss which increases the frequency and/or severity of a loss (ex: leaving keys in an unlocked car, neglecting a tree limb growing over roof)
legal hazard
characteristics of legal system or regulatory environment that increase the frequency and/or severity of a loss (ex: juries in some areas are more sympathetic than other areas)
risk classifications
pure vs speculative risk, diversifiable risk, nondiversifiable risk, systemic risk
pure risk
2 states: loss or no loss (ex: fire, cancer, dog bites a visitor)
speculative risk
3 states: loss, no loss/no gain, gain (ex: investment, gambling, drinking)
can you buy insurance for pure risks?
yes
can you buy insurance for speculative risks?
no
diversifiable risk
affects only individuals or small groups, can be reduced/eliminated through diversification, risks aren’t correlated (fire, theft, collision)
nondiversifiable risk
affects the entire economy or large numbers of groups, cannot be reduced/eliminated through diversification, government assistance may be needed to insure, risks are correlated (inflation, unemployment)
systemic risk
risk of collapse of an entire system or market due to the failure of a single entity or group of entities that can result in the breakdown of the entire financial system, instability in the financial system due to the interdependency between the players in the market
Bridge in London
example of systemic risk - wind and people stepping the same way caused the bridge to sway
major types of pure risks
personal risk, property risk, liability risk, loss of business income, cybersecurity
which pure risks are relevant to individuals and families?
personal risk, property risk, cybersecurity
which pure risks are relevant to businesses?
property risk, liability risk, loss of business income, cybersecurity, personal risk
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, disability, injury, poor health, inadequate retirement income
property risk
the possibility of losses associated with the destruction or theft of property
direct loss
cost to repair or replace property damaged by a peril
indirect loss
financial loss resulting as a consequence of a direct loss (ex: fire damages your home, you have to pay to live elsewhere while it’s repaired)
liability risk
legal liability (financial consequences) resulting from injuries or damages you caused to come else, no upper limit, liens can be placed on income / assets seized (ex: defense costs for lawyer)
loss of business income
if a business has to shut down for a period of time due to a physical damage loss, it is unable to generate an income
risk control
techniques to reduce the frequency or severity of losses
risk financing
techniques for funding losses
risk control
loss prevention, loss reduction, duplication, separation, diversification, avoidance
risk financing
retention, non insurance transfer, insurance
risk management
process that identifies loss exposures faced by an organization and selects the most appropriate techniques for treating such exposures
loss exposures
any situation or circumstance in which a loss is possible regardless of whether a loss actually occurs
steps in 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 needs to be protected? what perils are those assets exposed to? most important step, sources: loss history, financial statements, other firms, surveys, inspections
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 during its lifetime
probable maximum loss (PML)
the worst loss that is likely to happen
consider and select the appropriate risk management techniques
techniques: avoidance, loss prevention, loss reduction, duplication, separation, diversification
risk control - avoidance
a certain loss exposure is never acquired (proactive) or an existing loss exposure is abandoned (reactive), frequency is reduced to 0 but may not always be possible and has an opportunity cost
risk control - loss prevention
measures that reduce the frequency of a particular loss, does not completely eliminate risk (ex: TSA security)
risk control - loss reduction
measures that reduce the severity of a loss, no effect on the frequency of a loss (ex: recall of products, storm shelter)
risk control - duplication
having backups or copies of important documents or property available in case a loss occurs (ex: flash drive, spare tire/keys)
risk control - separation
dividing the assets exposed to loss to minimize the harm from a single event (ex: firewalls in buildings, companies with multiple warehouses)
risk control - diversification
reducing the change of loss by spreading the loss exposure across different parties, securities, or transactions (ex: having multiple suppliers and customer types)
risk financing techniques
retention, non insurance transfer, insurance
risk financing - retention
a firm or individual retains part or all of losses that can occur from a given risk, deductible
retention level: the dollar amount of losses that the individual/firm will retain
types of retention
unfunded retention: low severity/frequency, not putting money away for retention, just taking money out of checking or net income when needed
funded reserve: setting money aside for risks, for higher frequency risks
deductible: portion of the losses that you pay for out of pocket
captive insurer, self insurance, risk retention group
risk financing - retention (captive insurer)
insurer owned by a parent firm for the purpose of insuring the parent firm’s loss exposures
advantages: can help a firm when insurance is expensive or difficult to obtain, lower costs, easier access to reinsurance market, lower tax rate, favorable regulatory environment
risk financing - retention (self insurance)
a special form of planned retention by which part or all of a given loss exposure is retained by the firm, does not involve forming your own insurance company, part of funded reserve
risk financing - retention (risk retention group)
group captive that can write any type of liability coverage except employers’ liability, workers compensation, and personal lines; exempt from many state insurance laws (ex: medical malpractice)
advantages of risk financing -retention
save on loss costs, save on expenses, encourage loss prevention, increase cash flow
disadvantages of risk financing - retention
possible higher losses, possible higher expenses, possible higher taxes
risk financing - non insurance transfer
methods other than insurance by which a pure risk and its potential financial consequences are transferred to another party (ex: contracts, leases, hold harmless agreements)
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
disadvantages: contract language may be ambiguous, firm is still responsible for loss if the other part fails to pay, insurers may not give credit for transfers
risk financing - insurance
appropriate for low frequency, high severity loss exposures
advantages: firm is indemnified for losses, uncertainty is reduced, firm may receive valuable risk management services, premiums are income tax deductible
disadvantages: premiums may be costly, negotiation of contracts takes time and effort, the risk manager may become lax in exercising loss control
risk financing - insurance (deductible)
a specified amount subtracted from the loss payment otherwise payable to the insured
risk financing - insurance (excess insurance)
a plan in which the insurer pays only if the actual loss exceeds the amount a firm has decided to retain
risk financing - insurance (manuscript policy)
a policy specially tailored for the firm
high frequency, low severity
funded reserve (retain), loss prevention
low frequency, low severity
unfunded reserve
high frequency, high severity
avoidance, captive or risk retention group, loss prevention/reduction
low frequency, high severity
insurance, loss reduction
hard market
insurer profitability is declining, underwriting standards are tightened, premiums increase, and insurance is hard to obtain (usually in this type of market)
soft market
profitability is improving, standards are loosened, premiums decline, and insurance becomes easier to obtain
implement and monitor the chosen techniques
risk management policy statement, RM program should be periodically reviewed and evaluated to determine whether the objectives are being attained
risk management policy statement
outlines the risk management objectives of the firm and the company policy with respect to treatment of loss exposures
benefits of risk management
enables a firm to attain its pre loss and post loss objectives more easily, society benefits because both direct and indirect losses are reduced, can reduce a firm’s cost of risk
insurance
the pooling of accidental losses by transfer of such risks to insurers, who agree to compensate insureds for such losses, to provide other 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 actual results will approach the probable results expected from an infinite number of exposures
pooling of losses
the spreading of losses incurred by a few over the entire group, reduce variation which reduces uncertainty
standard deviation: average distance from the mean
payment of fortuitous losses
unforeseen and unexpected by the insured and occurs as a result of change
risk transfer
a pure risk is transferred from the insured to the insurer, who typically is in a stronger financial position (ex: car insurance, fire, life/health insurance)
indemnification
the insured is restored to its approximate financial position prior to the occurrence of the loss (not trying to profit from a loss, restore them back to their original position)
characteristics of an ideally insurable risk
large number of exposure units: enables the insurer to predict average loss based on the Law of Large Numbers
loss be accidental and unintentional: loss should be outside of insured’s control
loss must be determinable and measurable
loss should not be catastrophic to the insurer
change of loss must be calculable: must be able to calculate average frequency and severity
premium must be economically feasible
adverse selection
the tendency of people with a higher than average chance of loss to seek insurance at standard rates, which, if not controlled by underwriting, results in higher than expected loss levels (insuring high risk individuals usually due to asymmetric information)
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
utilizes a consumer’s credit history to predict the likelihood of future financial losses, ranges from 0 to 1000, the higher the score the less likely to have an insurance loss
how to avoid adverse selection
eliminate asymmetric information by collecting all of the information that may be relevant to the pricing and adjust the pricing based on this
types of private insurance
life and health, property and liability
private insurance - life insurance
pays death benefits to beneficiaries when the insured dies
private insurance - health insurance
covers medical expenses because of sickness or injury
private insurance - property insurance
indemnifies property owners against the loss or damage of real or personal property
private insurance - liability insurance
covers the insured’s legal ability arising out of property damage or bodily injury to others
private insurance - 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 part by contributions from employers and/or employees, benefits are heavily weighed in favor of low income groups (ex: Social Security, unemployment, Medicare, Medicaid)
other government insurance programs
FDIC: insures up to $250,000 in the bank
National Flood Insurance Program (NFIP, Fair Access to Insurance Requirements Plans (FAIR), Beach and Windstorm Plans
traditional risk management
risks evaluated in a “silo” (the unwillingness to share information or knowledge between employees or across different departments within a company) approach
evolution of traditional risk management
many companies began expanding their risk management programs to include speculative financial risks in the 1990s, some organizations have now gone further in their risk management programs to consider all risks faced by the organization
enterprise risk management (ERM)
a strategic business discipline that supports 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, considers all risks an organization faces across the entire enterprise, holistic/interconnected view of risk, typically headed by Chief Risk Officer (CRO) and used in large organizations, creates a “risk culture” within the organization in which everyone is responsible for identifying and managing risk
ERM - hazard risk
tradition risk, management types of risk (pure risks)
RM techniques: insurance, non insurance risk transfer, retention, loss prevention/reduction
ERM - operational risk
risks arising from day to day business operations: supply chain, manufacturing defects, customer service, cybersecurity, employment practices
RM techniques: multiple suppliers, employee training, customer surveys, dual factor authentication, firewalls, HR department, background checks, employee interview
ERM - financial risk
risks arising from changing conditions within financial markets: commodity prices, interest rates, foreign exchange rates
RM techniques: buy products in bulk, take advantage when interest rates decrease
ERM - strategic risk
uncertainty regarding an organization’s goals and objectives, and the organization’s strengths, weaknesses, opportunities, and threats (SWOT), long term
