RMIN Exam 1 Prep Flashcards
Risk
a calculated possibility of a negative outcome
Calculated Possibility
A probabilistic outcome (chance of loss, likelihood of loss) that is known or estimated
Ranges from 0 to 1 (0% to 100%)
Negative Outcome
- Loss
- Must be Quantifiable ($)
Frequency
- How often does a loss occur?
- Number of losses (fire, theft, collision) that courts within a specific time period
-Probability of a loss
of losses/ # of exposures
Ex: probability of a fire is .0071 per loss exposure per year
Severity
- How much does it cost when a loss does occur
- Dollar amount of loss for a specific peril (fire, theft, collision)
Total loss $/# of losses
Ex: average fire loss is $32,547
Peril
Cause of Loss
EX: fire, tornado, collision, burglary
Hazard
Condition that creates or increases the frequency and/or severity of a loss
- Doesn’t cause a loss
Physcial Hazard
a physical condition that increases the frequency and/or severity of a loss
Ex: leaking pipe, cracked sidewalk
Moral Hazard
prescence of insurance changes the behavior of the insured
Ex: using a hammer to create “hail” damage to the roof, exaggerating value of inured property, Great Recession
Moral (Attitudinal) Hazard
carelessness or indifference to a loss, which increases the frequency and/or severity of a loss
Ex: leaving car keys in an unlocked car, neglecting a tree limb growing over your roof
Legal Hazard
characteristics of legal system or regulatory environment that increases the frequency and/or severity of a loss
Ex: juries in some areas are more sympathetic than other areas (meaning larger damages awards in liability lawsuits)
Risk Classifications
Pure Risk
Speculative Risk
Diversifiable Risk
Nondiversifiable Risk
Systemic Risk
Pure vs. Speculative
Pure Risk → 2 future states (loss or no loss)
Ex: fire, cancer dog bites a visitor
Can BUY insurance
Speculative Risk → 3 future states (loss, no loss/no gain, gain)
Ex: Investment, gambling
CAN’T buy insurance
Diversifiable Risk
affects only individuals or small groups, not entire economy (car theft)
- Can be eliminated/reduced through diversification
- Risk aren’t correlated (fire, theft, collision)
Nondiversifiable Risk
affects the entire economy or large number of groups/persons within the economy
- Cannot be reduced/eliminated through diversification
Government assistance may be needed
- Risk are correlated (inflation, unemployment)
Systematic Risk
risk of collapse of an entire system or entire market due to the failure of a single entity or group of entities that can results in the breakdown of the entire financial system
Instability in the financial system due to the interdependence between players in the market
Ex: erickson and nokia phones; march 2000, a small fire occur dona single production line of a microchip plant
Personal Risk
directly affects an individuals or family; involves the possibility of loss of income, extra expenses, depletion of financial assets
What perils might be involved?
premature death, unemployment, disability/poor health, alcohol + drug addiction
Property Risk
possibility of losses associated with the destruction or theft of property
Direct loss: cost to repair or replace property damages 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 whilst its repaired
Liability Risk
legal liability (financial consequences) resulting from injuries or damages you caused to someone else
- No upper limit
- Liens can be placed on income, assets seized
Loss of Business Income
if a business has to shut down for a period of time due to a physical damages loss, its unable to generate income
Types of Pure Risk
Personal
Property
Liability
Loss of Business Income
Cyber Security
Risk Financing
Techniques for funding losses
- Retention: retaining part of all of losses that can occur from a given risk
-Active: deliberately retaining risk (choosing a high deductible)
- Passive: unknowing retaining risk (not purchasing disability insurance) - Noninsurance transfer
- Insurance
Insurance
pooling of fortuitous accidental losses by transfer of suck risk to insurers, who agree to indemnify compensate insureds for such losses, to provide other pecuniary monetary benefits on their occurrence, or to render services connected with the risk
Basic characteristics of insurance
Pooling of losses
Payment of fortuitous losses
Risk transfer
Indemnification
Pooling of Losses
Purpose is to reduce variation which reduces uncertainty (risk)
Losses incurred by the few are spread over the entire group so that in the process, average loss is substituted for actual loss
History
About 5000 years ago, around the Yangtze river near China merchants distributed their cargo between several smaller vessels protecting themselves from a complete loss
Law of Large Numbers → greater the number exposures, more closely will actual results approach the probable results expected from an infinite number of exposures
Payment of Fortuitous Losses
- Fortuitous: unforeseen and unexpected by the insured and occurs as a results of chance
- If you attempt to buy homeowner insurance when a hurricane approaches?
Risk Transfer
- Transferred from the insured to the insurer, who is typically is in a stronger financial position
Ex of pure risk that are transferred to insurers: fire, illness, injury
Indemnification
- Insured is restored to its approximate financial position prior to the occurrence of the loss
Ex: you are at fault for a car accident that damages your car and injures another driver. The driver suffered medical cost and sues you, your car insurance company indemnifies you and:
-Pays to repair their vehicle
-Helps pay their attorney fees
-Covers any settlement or judgment form the lawsuit
Characteristics of an IDEALLY Insurable Risk
large number of exposure units
loss must be accidental and unintentional
loss must be determinable and measurable
loss should not be catastrophic
chance of loss must be calculable
premium must be economicallt feasible
Large number of exposure units - charcteristc of an ideally insurable risk
- Enables the insure to predict average loss based on the law of large numbers
- Large number of similar (homogenous) exposure units needed
Should an insurance company insure things that they don’t insure a large number of? No
Loss must be accidental and unintentional- Characteristics of an IDEALLY Insurable Risk
Loss should be outside of insured’s control
Why?
Law of large number is based on randomness
Loss must be determinable and measurable - Characteristics of an IDEALLY Insurable Risk
Determinable
Can you determine if a loss occurred?
When would it be easy? Car accidents, destruction of property hard? Not property
Measurable
Can you determine the amount of the loss?
Loss should not be catastrophic- Characteristics of an IDEALLY Insurable Risk
Allows pooling techniques to work
Ex of catastrophes: terrorism, flood, earthquake
Solutions for insurancers:
Reinsurance
Diversification
What are catastrophic loss problems?
They don’t happen enough to have good data
Chance of loss must be calculable-Characteristics of an IDEALLY Insurable Risk
Must be calculate average frequency and average severity
Why? To calculate premium
Premium must be economically feasible- Characteristics of an IDEALLY Insurable Risk
Insured must be able to afford it
Would the premium be economically feasible for a 90 year old looking to buy life insurance? NO
Adverse Selection and Insurance
happens when people with a higher risk of loss are more likely to get insurance at average rates. This occurs because one party has more information about the risk than the other (asymmetrical information).
If not managed through underwriting (evaluating and classifying applicants) or policy provisions (e.g., suicide clauses in life insurance), it can lead to more claims and higher losses than expected.
Types of Insurance
Private and Goverment
Private Insurance
Life Insurance: pays death benefits to beneficiaries when the insured dies
Health insurance: covers medical expenses because of sickness or injury
Property: indemnifies property owners against the loss or damage of real or personal property
Liability: covers the insured’s legal liability arising put of property damage or bodily injury to others
Casualty: refers to insurance that covers whatever is not covered by fire, marine, and life insurance
Goverment Insurance
includes social insurance programs and other govt insurance plans
Social Insurance Programs
Financed entirely or in large part by contributions from employers and/or employees
Benefits are heavily weighted in favor of low income groups
Eligibility and benefits are prescribed by statue
Ex: old age, survivors and disability insurance (social security), unemployment, medicare, workers comp
Other Government Insurance Programs
Found at federal and state level
Ex: federal deposit insurance corporation (FDIC, NFIP, FAIR,
Benefits of Insurance to Society
Indemnification for loss
Reduction of worry and fear
Source of investment funds
Loss prevention
Enhancement of credit
Costs of insurance to society
expense loading is the amount needed to pay all expense
fradulent claims or inflated claims
higher premiums to cover addiontal losses reduce disposaible income and consumption of toher goods and services
Risk Management
process that identifies loss exposure faced by an organization and selects the most approporate technqauies for treating such exposures
Objectives of Risk Management
Risk management has objectives before and after a loss occurs
Pre-loss objectives:
Prepare for potential losses in the most economical way
Reduce anxiety
Meet any legal obligations
Post-loss objectives:
Survival of the firm
Continue operating
Stability of earning
Continued growth of the firm
Social responsibility
Steps in the Risk Management Process
- identify potential losses
- measure and analyse the loss exposure
- Select the appropriate combination of techniques for treating the loss exposures
- Implement and monitor the risk management program
- Idenitfy the Loss Exposure
Important loss exposures:
Property loss exposures
Liability loss exposures
Business income loss exposures
Human resources loss exposures
Crime loss exposures
Employee benefits loss exposures
Foreign loss exposures
Intangible property loss exposures
Failure to comply with government laws and regulations
Sources of information for identifying loss exposures:
Risk analysis questionnaires and checklists
Physical inspection
Flowcharts
Financial statements
Historical loss data
- Measure and Analyxe the Loss Exposure
Loss frequency –> how often does the loss occur?
Loss severity –> How much does it cost when a loss does occur?
Guidelines for measuring severity:
–Maximum possible loss: worst loss that could happen to the firm during its lifetime
–Probable maximum loss: worst loss that is likely to happen
- Select the appropriate combination of techniques for treating the loss exposures
Risk control- techniques to reduce frequency or severity of losses
Avoidance
Loss prevention
Loss reduction
Duplication
Separation
Diversification
Risk financing: techniques that provide for the funding of losses
- Retention
Determining retention levels
Paying losses: current income, (un)funded reserve, line of
credit,
captive insurer
Self-insurance
Risk retention groups
Advantages and disadvantages
Risk financing - Noninsurance transfers
- 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
- Methods other than insurance by which a pure risk and its potential financial consequences are transferred to another party
- Commercial insurance: Appropriate for low frequency, high severity loss exposure
Advantages of insurance
Disadvantages of insurance
- Implement and Monitor the Risk Management Program
Risk management policy statement and risk management manual
Cooperation with other departments
Periodic review
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.
Also useful in personal risk management
Personal Risk Management
The same principles applied to corporate risk management apply to
personal risk management
Enterprise Risk Management (ERM)
A strategic approach to business that helps an organization achieve its objectives by identifying and addressing all types of risks and managing their combined effects as a unified risk portfolio.
Differences between Traditional Risk Management and ERM
Traditional:
Focus: Primarily deals with insurable, pure risks, such as: Personal risks, liability risk(direct loss), income risk(indirect losses)
Enterprise Risk Management (ERM):
Focus: Supports organizational objectives by managing the combined impact of all risks, recognizing their interrelationships and cumulative effects.
Goal: Aligns risk management with overall business strategy for better decision-making and value creation.
In summary, TRM focuses on individual risks in isolation, while ERM adopts a broader, strategic perspective to manage risks as a whole.
ERM Process
Adoption/Implementation
Risk Identification
Risk Analysis
Selection and Implementation of Risk Treatment Measures
Monitor the Program and Take Corrective Actions
Types of Risks within ERM
Hazard Risk
Operational Risk
Financial Risk
Strategic Risk
Compliance Risk
Hazard Risk
Traditional risk (property, liability (pure risk))
Techniques to treat:
Insurance
Non Insurance risk transfer retention
Loss prevention/reduction
Operational Risk
Risk arising from say to day business operations:
Supply chain
Manufacturing defects
Customer service
Cybersecurity
Employment practices
RM techniques to employ:
Avoidance, loss prevention, loss reduction, duplication, separation, diversification
Financial Risk
Risk arising from changing condition within financial markets:
Commodity prices
Interest rates
Foreign exchange rates
RM techniques you employ?
Diversification
Strategic Risk
Uncertainty regarding an organization’s goals and objectives, and the organization’s strengths, weakness, opportunities, and threats (SWOT)
Compliance and Regulatory Risk
Compliance is the risk that a company will have been determined to be in violation of already established laws or regulations
Regulatory is the risk that a change in laws and regulations will materially impact a security, business, sector, or market
ERM tools
Risk Management Information System (RMIS)
Risk Score
Risk Register
Risk Map
ERM Program
Risk appetite: total exposure that an organization is willing to accept, given the risk and return trade-off for an individual risk or in aggregate for the portfolio of risk
Risk tolerance: amount of uncertainty that an organization is willing to accept
Advantages of an ERM program
Improved risk assessment
Integrated response to the full range of risks
Alignment with organization’s risk tolerance and its strategies
Fewer operational surprises and losses
Barriers to an ERM Program
Lack of commitment from company leadership
Rigid organizational culture
Disagreements between departments over responsibilities
Technological difficulties
Lack of information sharing
Hard Market
tight standard, high premium, unfavorable insurance terms, more retention
Soft Market
loose standards, low premium, favorable insurance terms, less retention
Combined Ratio
Calculated by dividing the sum of the company’s underwriting expenses and incurring losses by its earned premium
High the ratio, lower the profitability
Good measure of an insurance company’s profitability
