Test (Chapters 1-4) 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
0 (calculated possibility)
0%; impossible event (no risk)
0.5 (calculated possibility)
highest risk (most uncertainty)
1 (calculated possibility)
100%; certain event (no risk)
negative outcome
loss; must be quantifiable (in $)
frequency
the number of losses that occur within a specified time period; probability of a loss
frequency equation
number of losses/number of exposures
severity
the dollar amount of loss for a specific peril
severity equation
total losses ($)/number of losses)
peril
cause of loss (ex: fire, windstorm, flood, collision, burglary, etc.)
hazard
condition that creates or increases the frequency and/or severity of a loss; does not cause a loss
four types of hazards
physical, moral, morale (attitudinal), legal
physical hazard
a physical condition that increases the frequency and/or severity of a loss (ex: pipe breaking; electrical)
moral hazard
the presence of insurance changes the behavior of the insured (ex: using a hammer to create “hail” damage to a roof; exaggerating the value of insured property)
morale 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 increase the frequency and/or severity of a loss (ex: juries in some jurisdictions are more sympathetic than other areas)
pure risk
2 future states (loss or no loss); ex: auto accident, fire, flood, cancer, slip & fall; can buy insurance for this risk
speculative risk
3 future states (loss, no loss/no gain, gain); ex: investment, gambling; cannot buy insurance for this risk
diversifiable risk
affects only individuals or small groups (car theft); can be reduced or eliminated by diversification; risks are not correlated
nondiversifiable risk
affects the entire economy or large numbers of groups/persons within the economy; cannot be reduced/eliminated through diversification; government assistance may be needed to insure; risks are correlated (inflation, unemployment)
enterprise risk
encompasses all major risks faced by a business firm (pure, speculative, strategic, operational, financial risks)
systemic 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 result in the breakdown of the entire financial system; instability in the financial system due to the interdependency between the players in the market
types of pure risk
personal, property, legal liability, loss of business income, cyber security
personal risk
directly affects an individual or family; involves the possibility of loss of income, extra expenses, depletion of financial assets
perils involved with personal risk
premature 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 to property
cost to repair or replace property damaged by a peril
indirect loss to property
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)
legal liability risk
- Legal liability (financial consequences) resulting from injuries or damages you caused to someone else.
- Defense costs
- No cap on losses (in most situations)
- Liens can be placed on income, assets seized.
loss of business income
if a business has to be shut down for a period of time due to a direct physical damage loss, it is unable to generate an income (indirect loss)
burden of risk on society
-Need for larger emergency funds
-Loss of needed goods and services
-Fear and worry
techniques for managing risks
risk control and risk financing
risk control
techniques that reduce the frequency or severity of losses
risk financing
techniques that provide for the funding of losses
loss prevention
reduces frequency (ex: airport security, employee safety training programs, protective equipment/clothing)
loss reduction
reduces severity (fire & leak sprinklers); can occur pre-loss or post-loss
avoidance
technique in which: a certain loss exposure is never acquired (proactive), an existing loss exposure is abandoned (reactive)
retention
retaining part or all of losses that can occur from a given risk
active retention
deliberately retaining risk (choosing a high deductible)
passive retention
unknowingly retaining risk (not purchasing disability insurance)
noninsurance risk transfer
a risk financing technique in which one party transfers the potential financial consequences of a particular loss exposure to another party that is not an insurer (by contractual agreement)
insurance
the pooling of accidental losses by transfer of suck 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
pooling of losses
the spreading of losses incurred by a few over the entire group; purpose is to reduce variation which reduces uncertainty (risk)
payment of fortuitous losses
Insurance pays for losses that are unforeseen, unexpected, and occur as a result of chance
risk transfer
a pure risk is transferred from the insured to the insurer, who typically is in a stronger financial position
indemnification
the insured is restored to its approximate financial position prior to the occurrence of the loss
law of large numbers
the greater the number of exposures, the more closely will actual results approach the probable results expected from an infinite number of exposures
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 (to the insurer)
- Chance of loss must be calculable
- Premium must be economically feasible
large number of exposure units
*Enables the insurer to predict average loss based on the Law of Large Numbers.
*Large number of similar exposure units needed.
loss must be accidental and unintentional
- loss should be outside of insured’s control
- because Law of Large Numbers is based on randomness
- If the insured can deliberately cause a loss that the insurer covers, the premium is increased
loss must be determinable and measurable
determinable (can you determine if a loss occurred); measurable (can you determine the amount of the loss)
loss should not be catastrophic to the insurer
- allows pooling techniques to work
- examples of catastrophes: terrorism, hurricane/named windstorm, flood, earthquake)
- solutions for insurers: reinsurance or diversification
chance of loss must be calculable
must be able to calculate average frequency and average severity
premium must be economically feasible
insured must be able to afford it
adverse selection
the tendency of persons with a higher than average chance of loss to seek insurance as standard (average) rates, which, if not controlled by underwriting, results in higher than expected loss levels; typically results from asymmetric information
asymmetric information
occurs when one party has information that is relevant to transaction that the other party does not have
underwriting risks
the process of selecting and classifying applicants for insurance
types of insurance
private and government insurance
types of private insurance
life, health, property, liability, casualty insurance
life insurance
pays a death benefit to beneficiaries when an insured dies
health insurance
pays medical expenses because of sickness or injury (non work related injuries)
property insurance
indemnifies property owners against the loss or damage of real or personal property
liability insurance
covers the insured’s legal liability arising out of property damage or bodily injury to others
casualty insurance
broad term that refers to insurance that covers whatever is not covered by fire, marine, and life insurance; frequently it includes auto, liability, and workers’ compensation
government insurance
- financed entirely or in large part by contributors from employers and/or employees
- benefits are heavily weighted in favor of low-income groups
- eligibility and benefits are prescribed by statute
- found at both the federal and state level
risk management
process that identifies loss exposures faced by an organization and selects the most appropriate techniques for treating such exposures
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
measure loss exposures
estimate the frequency and severity of loss exposures
analyse loss exposures
rank loss exposures according to relative importance; severity is more important
