Risk Management: Definitions, Concepts, and Applications, Exams of Risk Analysis

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RMIN 4000 Test 1(Chapters 1-4) with

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Traditional definition of risk - ANSWER-uncertainty Definition of risk - ANSWER-uncertainty about chance, timing, or amount of loss Chance of loss - ANSWER-the probability that an event will occur Objective risk - ANSWER-the relative variation of actual loss from expected loss Law of Large Numbers - ANSWER-Objective risk varies inversely with the square root of the number of cases E.X. car insurance subjective risk - ANSWER-uncertainty based on a person's mental condition or state of mind peril - ANSWER-the cause of the loss hazard - ANSWER-a condition that increases the frequency or severity of the loss types of hazards - ANSWER-physical, morale, moral, legal pure risk - ANSWER-chance of loss or no loss and no chance of gain speculative risk - ANSWER-chance of loss, no loss, or gain particular risk - ANSWER-a risk that affects only individuals as individuals fundamental or systematic risk - ANSWER-risk that affects a large number of individuals or the entire economy enterprise risk - ANSWER-a term that encompasses all major risks faced by a business firm. -operational risk -financial risk -strategic risk -reputation risk personal risks - ANSWER-risk of premature death risk of insuffiiciet income during retirement risk of poor health

risk of unemployment property risks - ANSWER-direct loss indirect loss direct loss - ANSWER-financial loss that results from the physical damage, destruction, or theft of the property indirect loss - ANSWER-financial loss arising from loss of use of property liability risks - ANSWER-responsibility for actions that cause injury or property damage to another burden of risk on society - ANSWER--requires emergency funds -outlays to reduce risk -expense of financing potential/actual losses -worry and fear -time -losses for which we are not indemnified cost of risk - ANSWER--outlays to reduce risk -opportunity cost -expenses from financing potential losses -cost of losses not reimbursed Definition of Insurance - ANSWER-insurance is the pooling of fortuitous losses by transfer of such risks to insurers, who agree to indemnify insureds for such losses, to provide other pecuniary benefits on their occurrence, or to render services connected with the risk fortuitious - ANSWER-random (accidental losses) indmenification - ANSWER-"to make whole" means that the insured is restored to the condition prior to the loss pooling of losses - ANSWER-spreading losses of a few over an entire group -risk reduction based on the law of large numbers payment of fortuitous losses - ANSWER-pay for losses that are unexpected, unforeseen, or occur as a result of chance risk transfer - ANSWER-pure risk transfer from the insured to insurer indemnification - ANSWER-insured restored to approximate financial position prior to loss

expected loss formula - ANSWER-multiply each loss amount by its associated probability and then add them all together Standard deviation of expected loss formula - ANSWER-take the square root of each probability of risk times the (amount of loss minus the expected loss) squared added together Why does the pooling of losses work - ANSWER-as the pool increases the expected loss stays the same, while the standard deviation decreases Ideally insurable risk - ANSWER--large number of homogenous exposure units -accidental and unintentional loss -deteminable and measurable loss -no catastrophic loss -calculable chance of loss -economically feasible premium adverse selection - ANSWER-the tendency of persons with a higher than average chance of loss to seek insurance at standard (average) rates, which if not controlled by underwriting, results in higher than expected loss levels underwriting - ANSWER-involves the selecting and classifying insurance applicants -has certain standards that must be met for standard/preferred rates -if standards are not met higher rates apply policy provisions - ANSWER-suicide clause in life insurance insurance vs. gambaling - ANSWER-gambling creates risk, insurace handles existing risk -gambling is zero sum, insurance in win-win insurance vs. hedging - ANSWER-insurance uses the law of largge numbers to reduce risk -hedging transfers risk (to speculators who willingly take on the risk) Private insurance - ANSWER-life insurance health insurance property insurance liability insurance Government insurance - ANSWER-social insurance-OASDI (social security), Medicare, Unemployment social benifits of insurance - ANSWER-indemnification for loss reduction of worry and fear source of investment funds

loss prevention social costs of insurance - ANSWER-cost of claims increased moral harazard cost of insurance mechanism Risk preferences - ANSWER-risk neutral risk averse risk seeking Utility - ANSWER-a measure of satisfaction based on an individual's consumption of goods St. Petersburg theory - ANSWER-as wealth increases the utility of each dollar decreases Expected utility formula - ANSWER-probability of loss X utility of loss + probability of no loss X utility of no loss = Pure Premium Final Expected Utility formula - ANSWER-square root of (initial wealth- pure premium) Expected utility formula with insurance - ANSWER-Square root of (intial wealth - pure premium - loading expense) Defintion of risk management - ANSWER-formal decision making process to address risk, including the potential financial consequences associated with loss exposures loss exposure - ANSWER-any item exposed to loss; any situation in which a loss may occur Risk Management Process - ANSWER-1. identify potential losses

2. evaluate potential losses
3. select the appropriate risk management techniques
4. implement and monitor the risk management program Ways to identify loss exposures - ANSWER-questionnares physical inspection flowcharts financial statements historical loss data consider industry trends and market changes Evaluating loss exposures - ANSWER--loss frequency -loss severity risk management matrix - ANSWER-see picture in chapter 3

Risk control techniques - ANSWER-avoidence loss prevention loss reduction risk financing - ANSWER-techniques that provide for the funding of losses retention - ANSWER-firm retains part or all of the losses that can result from a given loss -most effective when: no other method is available, the worst possible loss is not that serious, losses are fairly predictable retention level - ANSWER-the dollar amount of losses the firm will retain Ways to pay for retained losses - ANSWER-current net income unfunded reserve funded reserve credit line captive insurer - ANSWER-an insurer owned by a parent firm for the purpose of insuring the parent firm's loss exposure Reasons Captives are formed - ANSWER-parent company may have difficulty obtaining insurance. favorable regulatory conditions. costs may be lower than purchasing commercial insurance. a captive insurer has easier access to a reinsurer. a captive insurer can become a source of profit. Premiums paid to a captive may be tax deductable under certain conditions. Risk retention group - ANSWER-a group captive that can write any type of liability coverage except employer liability, workers comp, and personal lines Risk managers and Insurance - ANSWER-the risk manager selects the coverages needed and policy provisions. the risk manager selects an insurer or several insurers. the risk manager negotiates the terms of the insurance contract. information concerning insurance coverages must be disseminated to others in the firm. the risk manager must periodically review the insurance program. non insurance transfer - ANSWER-a method other than insurance by which a pure risk and its potential financial consequences are transferred to another party. ex: contracts, leases, hold harmless agreements implementation of a risk management program begins with a risk management policy statement that: - ANSWER-outlines the firm's risk management objectives. outlines the firm's policy to treat loss exposures. educates top level executives in regard to the risk

management process. gives the risk manager greater authority. provides standards for judging the risk manager's performance. a risk management manual may be used to: - ANSWER-describe the risk management program. train new employees. state risk manager's responsibilities, objectives, available techniques, and responsibilities of other parties. financial risk management - ANSWER-refers to the identification, and treatment of speculative financial risks double trigger option - ANSWER-a provision that provides for payment only if two specified losses occur Enterprise Risk Management - ANSWER-a comprehensive risk management program that addresses the organization's pure, speculative, strategic, and operational risks. credit default swap - ANSWER-an agreement in which the risk of default of a financial instrument is transferred from the owner of the financial instrument to the issuer of the swap the underwriting cycle - ANSWER-refers to the cyclical pattern of underwriting stringency, premium levels, and profitability. hard market - ANSWER-tight underwriting standards, high premiums, and unfavorable insurance terms lead to more retention soft market - ANSWER-loose underwriting standards, low premiums, and favorable insurance terms lead to less retention the combined ratio is often used to demonstrate the status of the underwriting cycle - ANSWER-paid losses+loss adjustment expenses+underwriting expenses/premiums industry capacity - ANSWER-the relative level of suplus surplus (insurance) - ANSWER-the difference between an insurer's assets and liabilities securitization of risk - ANSWER-insurable risk is transferred to the capital markets through creation of a financial instrument catastrophe bond - ANSWER-permits the issuer to skip or defer scheduled payments if a catastrophic loss occurs insurance option - ANSWER-an option that derives value from specific insurable losses or from an index of values

weather option - ANSWER-provides payment if a specified weather contingency (temp. above a certain level, ie) occurs loss forcasting - ANSWER-probability analysis regression anaylsis loss distibutions probability anaylsis - ANSWER-involves not only examining probabilities, but also whether losses are related or not regression analysis - ANSWER-characterizes the relation between two or more variables and uses this to predict values of a variable loss distributions - ANSWER-a probability distribution of losses that could occur risk management information system (RMIS) - ANSWER-a computerized database that permits the risk manager to store and analyze risk management data Value at Risk (VAR) analysis - ANSWER-calculating the worst probable loss likely to occur in a given time period under regular market conditions at some level of confidence. catastrophe modeling - ANSWER-a computer assisted method of estimating losses that could occur as a result of a catastrophic event