Topic 18 Managing risk Flashcards
- Against what type of risk is insurance designed to provide protection?
Insurance is designed to protect against pure (one way) risk.
- ‘Explain how risk based management works.
Risk based management’ is based on continual reviews of the risks facing the business, through a process of identifying risks, assessing their potential impact, prioritising them and devising ways of controlling those that appear significant.
- Explain the difference between risk retention and risk transfer.
Risk retention refers to methods of risk containment in which an organisation bears the risk itself: if an adverse outcome occurs, it will suffer the full amount of the loss itself. Risk transfer refers to methods of shifting the cost of the risk to an unrelated third party, such as an insurance company.
- Give an example of ‘risk sharing’.
Examples of risk sharing include:
an excess on an insurance policy, such as car insurance, private medical insurance and home contents insurance, whereby the insurer agrees to pay any losses suffered by the policyholder in excess of a stated amount;
finite risk insurance, which involves the transfer of risk up to a maximum limited (finite) amount. For example, a company might agree that in the event of a large claim being made under the terms of the policy, an upward adjustment will be made retrospectively to the insurance policy premium. In effect, the insurance policy would be sharing some of the unforeseen loss with the insured.
- How might an investor reduce their exposure to non systematic risk?
Non systematic risk can be reduced by diversification – spreading the risk by investing in a range of company shares rather than in the shares of just one company.
- What is a ‘put option’, and how can it help a share investor to hedge risks?
Put options give the holder the right (but not the obligation) to sell a share to the option seller at a fixed price at, or by, a stated future date. If the share’s market price drops below the option (strike) price they can sell it for more than its market value, thus reducing (or eliminating) their losses.
- In relation to investments, explain what is meant by the terms capital risk andshortfall risk.
Capital risk is the risk of losing capital. Shortfall risk is the risk of an investment not reaching its expected or required target sum.
- In relation to investors, explain what is meant by each of the following terms.
Risk averse: people who do not want to take any risk at all.
Cautious: people who are prepared to take a very small risk.
Balanced: people who appreciate that there is a link between risk and reward. They may be prepared to take a degree of risk if the rewards are attractive, but will want to limit the risk.
Speculative (or adventurous): people who are prepared to take a significant element of risk in order to maximise the potential returns.
- What is seen as an ideal number of shares in a portfolio to achieve diversification?
Experts consider a portfolio of 30 different shares to be the ideal diversification.
